Equity Risk Premiums

Equity risk premiums are a central component of every risk and return model in finance. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. In the standard approach to estimating equity risk premiums we use historical returns, with the difference in annual returns on stocks and bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and noisy. We suggest ways in which equity risk premiums can be estimated for these markets, using a base equity premium and a country risk premium. Finally, we suggest an alternative approach to estimating equity risk premiums that requires no historical data and provides updated estimates for most markets.The notion that risk matters, and that riskier investments should have a higher expected return than safer investments, to be considered good investments, is intuitive. Thus, the expected return on any investment can be written as the sum of the riskfree rate and an extra return to compensate for die risk. The disagreement, in both theoretical and practical terms, remains on how to measure this risk, and how to convert the risk measure into an expected return that compensates for risk. This paper looks at the estimation of an appropriate risk premium to use in risk and return models, in general, and in the capital asset pricing model, in particular.