Thursday, February 05, 2009

SSRN-The Equity Premium in 100 Textbooks by Pablo Fernandez

So which is it? In class this week we have been discussing CAPM and the question has some up a few times as to what is the market risk premium. I guess we are not the only ones who have some uncertainty on this issue. Pablo Fernandez shares with us his working paper on the issue.

SSRN-The Equity Premium in 100 Textbooks by Pablo Fernandez: "[I review] 100 finance and valuation textbooks published between 1979 and 2008 (Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Weston, Arzac...) and find that their recommendations regarding the equity premium range from 3% to 10%, and that several books use different equity premia in different pages.

Some confusion arises from not distinguishing among the four concepts that the word equity premium designates: Historical equity premium, Expected equity premium, Required equity premium and Implied equity premium."

A look in:

"... The average is 6.6%. Figure 1 is in line with an update of Welch (2000), who reports
that in December 2007, 90% of the professors used in their classrooms equity premiums between 4% and 8.5%, and with Fernandez (2008) who reports that in June 2008 finance professors in Spain used equity premiums between 3.5% and 10% (average 5.5%).

Figure 1 of the paper is very interesting:

After this he goes on to show what each author has used for the Risk Premium in different editions of the book.

So if you are not sure which premium you should use, I guess you are not alone. What do I use in class? Usually 6% but this follows a discussion of why risk premiums may change (transaction costs, increased/decreased risk aversion, more/less volatile economy).

Interesting work. Must have taken a while to go through 100 text books.

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