By rule of thumb, when a market is perceived to be overvalued, the equity risk premium
normally rises, which bring down stock prices.
Comparing the equity risk premium
of the US market with the one of the Euro zone shows that the US is well below its long- term average (at 3.5 per cent vs.
Here [k.sub.e] is the cost of equity capital, [R.sub.f] is the risk-free reference rate in a developed country, MMERP is the mature market equity risk premium
, [[beta].sub.c] is the exposure to market risk, CDS is the country credit default swap rate, and [[lambda].sub.e] is the exposure to this risk factor.
Equity risk premium
, functional forms of the alternative models and econometric issues are discussed in this part.
If we fix t, and let k vary, we trace the term structure of the equity risk premium
. Third, if expectations are rational, because the unexpected component [error.sub.t+k] has mean zero and is orthogonal to expected returns, the ERP is always less volatile than realized excess returns.
So they are now thinking, 'How can I diversify away from the equity risk premium
?' They're looking at various return drivers, including an illiquidity premium, a term premium, a credit premium, or a skill premium--for example, when you invest with a hedge fund manager who is hopefully going to bring you some skill."
This stellar stock market rally was made possible by increased capital flows into Europe, a valuation rerating and a fall in the equity risk premium
. The same macro process happened in January and February 2015.
CAPM estimates the opportunity cost of investing in firm i, also known as firm i 's "cost of equity capital," as the sum of the risk free rate of return (RFR), normally measured as the return on US government bonds, and firm i 's equity risk premium
. Formally, according to the CAPM, E([R.sub.i]), the expected cost of equity capital for firm i is
The first risk premium is the equity risk premium
(ERP) that measures the additional compensation that investors demand for investing in stocks rather than bonds free from default risk.
Combined with a more benign bond environment, gearing, and an increase in equity risk premium
, this saw a strong rally in the area.
This seeming contradiction is explained by a phenomenon known as the equity risk premium
: Over the long haul, equities have earned about 3% more per annum than bonds.
"Given the upgrade to the MSCI EM Index and the relatively stable risk profile of several Qatari firms, we have opted to reduce our equity risk premium