Analyzing the Equity Risk Premium
December 21, 2015

The equity risk premium (ERP)—the expected return on stocks in excess of the risk-free rate—reached heightened levels in 2012 and 2013 not seen since the 1970s, a recent Federal Reserve Bank of New York study finds. Furthermore, the report argues that the ERP was high during that time because Treasury yields were unusually low and not because stocks were expected to have high returns.

The ERP is a key variable in the theory and practice of asset pricing that is used as a leading indicator of economic activity, as well as in firms’ cost of capital calculations, individuals’ savings decisions, and government budgeting plans.

In their study, New York Fed staffers Fernando Duarte and Carlo Rosa analyze twenty different models of the ERP and combine them in an optimal way to obtain a single ERP estimate. They find that there is substantial heterogeneity across model estimates, though the disagreement has recently decreased. Their methodology places the ERP for the period June 2012 to June 2013 at around 12 percent, close to levels reached in the mid- and late 1970s, when the ERP was highest in their sample. One implication of the ERP being driven by bond yields rather than expected stock returns is that traditional indicators of the ERP, such as simple valuation ratios, may not be as good a guide to future excess returns as they have been in the past.

Fernando Duarte is an economist in the Bank’s Research and Statistics Group. Carlo Rosa is a senior economist in the Bank’s Markets Group.

Their article can be read in full in the latest Economic Policy Review.

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