The UK Equity Premium: 1901–2004

Abstract:  This paper examines the UK equity premium over more than a century using dividend growth to estimate expectations of capital gains employing the approach of Fama and French (2002) . Over recent decades estimated equity premia implied by dividend growth have been much lower than that produced by average stock returns for the UK market as a whole; a finding corroborated by all economic sub-sectors. The empirical analysis suggests this is primarily due to a declining discount rate, during the latter part of the 20th century, which would rationally stimulate unanticipated equity price rises during this period. Thus, I conclude that historical stock returns over recent decades have been above investors' expectations.     

International variations in expected equity premia: Role of financial architecture and governance

Estimates of ex-ante equity premia are important in planning investments in pension funds, life insurance pools, and for other long-term financial obligations or goals. However, while global cross-border investment positions and flows have been rising, there is little research on non-US ex-ante equity premia or on their determinants in a global setting. This paper uses data on a recent 8-year period from 33 countries and models simultaneously our estimate of the ex-ante equity premium as a dependent variable and our measure of financial architecture as an instrumental variable. We document that ex-ante equity premia are larger in countries that have a more bank-oriented financial architecture, are wealthier, and have better governance. These results are robust to alternative model specifications and estimation techniques. Given the importance of equity premia and financial architecture, these results should be of much interest to scholars, managers, regulators, and policy makers.     

Returns after personal tax on UK equity and gilts, 1919–1998

This paper investigates whether personal tax could help explain the size of the historic equity premium in the UK measured before personal tax. If there has been a higher tax burden on equity, some of the premium could be viewed as compensation for tax. It is estimated here that personal tax reduces the arithmetic mean nominal return on equity from 13.3% to 11.1% pa during the period 1919–1998, and the mean return on gilts from 7.1% to 5.6% pa. Thus, personal tax accounts for a slightly higher proportion of the before-tax return on gilts than on equity, implying that the equity premium is not a compensation for a higher tax burden on equity.     

A股市场股权风险溢价的历史及启示

本文计算了1992～2000年、2001～2005年以及1992～2005年三个时间窗口下A股市场的股权风险溢价率；基于历史数据，就投资者所要求的股权风险溢价、通货膨胀与股权风险溢价的关系等问题进行了初步分析；相关分析也隐含了A股市场发展的政策建议。     

A NEW MODEL FOR ESTIMATING RISK PREMIUMS (ALONG WITH SOME EVIDENCE OF THEIR DECLINE)

This article uses the Gordon growth model with a novel method for forecasting dividend growth rates to estimate the equity cost and associated risk premium for a sample of Canadian telecommunications companies. The results suggest that the Telco risk premium has declined significantly since the early 1980s. Moreover, this decline is accentuated when measured over long Canada yields, rather than over similarly taxed, longterm preferred yields.
The findings of this study also suggest that the inverse relationship between utility risk premium and market interest rates reported by studies of U.S. utilities does not hold in Canada. If anything, the Telco risk premium has tended to vary directly with the level of market interest rates, with risk premium falling along with the general decline in rates. The main reason for these results seems to be the significant increase in interest rate risk, which has caused the long Canada yield to be a very poor proxy for the longterm, riskfree rate.
One practical implication of this finding is that companies that estimate equity costs as a premium over longterm government bond yields are probably seriously overestimating the cost.     

An introduction to security returns

The equity premium - the difference between the return achievable from investment in the equity market (R_M ) and the risk-free rate of return (R_F )- plays an important part in corporate finance. The expression equity premium (sometimes referred to as the equity risk premium) is used to denote the ex ante expectation of investors. The term excess return refers to the ex post achievement of stock returns over and above the risk-free return. If we compare US and UK returns, we find that total returns, real returns and the value of (R_M - R_F ) are all marginally higher for the UK. Summarized evidence appears in Table 1 and Table 6. Such greater returns may be due to an increased risk premium related to increasing unexpected inflation. Particularly important in estimating the equity risk premium is whether excess returns are measured using a geometric or an arithmetic mean return. To a significant extent, this question revolves around mean reversion in stock returns. Evidence of mean reversion is substantial, although it cannot be proved unequivocally. Given the weight of evidence of mean reversion, there may be a strong case for the use of a geometric mean with an equity premium of between 3% and 5% - or even less.     

Using Forecasts of Earnings to Simultaneously Estimate Growth and the Rate of Return on Equity Investment

We develop a method for simultaneously estimating the cost of equity capital and the growth in residual earnings that are implied by current stock prices, current book value of equity, and short-term forecasts of accounting earnings. We demonstrate the use of our method by calculating the expected equity risk premium. Our estimate is higher than estimates in extant studies that are based on the same earnings forecast data. The main difference between our study and these papers is that while they provide arguments supporting an assumed rate of growth beyond the forecast horizon, we estimate this rate.     

Re-examination of the historical equity risk premium in Australia

In light of the ongoing debate over the value of the equity risk premium, its increasing use in the regulatory setting, and the impact of dividend imputation on the premium, this paper presents a timely new look at the historical equity risk premium in Australia, and provides an improved understanding of the historical record. We document concerns about data quality that become increasingly important the further back in time one looks. In particular, there are sufficient question marks over the quality of data prior to 1958 to warrant any estimates based thereon to be treated with caution. Accordingly, we present a new set of estimates of the historical equity risk premium corresponding to periods of increasing data quality but of decreasing sample size. Relative to bonds (bills), the equity premium has averaged 6.3 per cent (6.8 per cent) per annum over 1958–2005, which is a period of relatively good data quality. Together with other results in the paper, the findings reveal a historical estimate that is substantially less than widely cited historical studies would otherwise indicate. We reconcile prior evidence through documenting a dividend adjustment that has typically been overlooked. We also provide estimates that incorporate an adjustment for imputation credits.     

Long-term reversals in the corporate bond market

Long-term reversals in corporate bonds are economically and statistically significant in a comprehensive sample spanning the period 1977 to 2017. Such reversals are stronger for bonds with high credit risk and more binding regulatory, capital, and funding liquidity constraints. Bond long-term reversal is not a manifestation of the equity counterpart and is mainly driven by long-term losers. A long-term reversal factor carries a sizable premium and is not explained by long-established equity and bond market factors. Thus, past returns capture investors’ ex-ante risk assessment and the degree of institutional constraints they face, so losing bonds command higher expected returns.     

Equity premium prediction and the state of the economy

We detect cyclical variation in the predictive information of economic fundamentals, which can be used to substantially improve and simplify out-of-sample equity premium prediction. Economic fundamentals based on stock-specific information (notably the dividend yield) deliver better predictions in expansions. Economic fundamentals based on aggregate information (notably the short rate) deliver better predictions in recessions. Accordingly, a simple forecast combination of one predictor that generates cyclical forecasts and one predictor that generates countercyclical forecasts can deliver statistically significant and economically valuable equity premium predictions in both expansions and recessions. A prominent two-predictor forecast combination that performs well is the dividend yield and the short rate. Strategies designed for ex-ante timing of the business cycle can provide additional economic gains in equity premium prediction.     

Isolating the disaster risk premium with equity options

The US equity risk premium is approximated with a mean unhedged equity return. I utilize out-of-the-money put options to obtain a hedged equity return, which allows me to quantify the disaster risk premium as the difference between the means of unhedged and hedged equity returns. I demonstrate that a substantial fraction of the U.S. equity risk premium over the period from 1996 to 2016 is attributed to disasters defined as stock price depreciations below a pre-specified strike price. Employing alternative hedging schemes increases the contribution of disasters to the equity risk premium.     

The Equity Premium: Consistent with GDP Growth and Portfolio Insurance

We find that the long‐term equity premium is consistent with both GDP growth and portfolio insurance. We use a supply‐side growth model and demonstrate that the arithmetic average stock market return and the returns on corporate assets and debt depend on GDP per capita growth. The implied equity premium matches the U.S. historical average over 1926–2001. Separately, we find that the equity premium tracks the value of a put option on the S&P 500. Our theory predicts a smaller equity premium in the future, assuming that the recent regime shifts in dividend policies, interest rates, and tax rates are permanent.     

Beyond CAPM: estimating the cost of equity considering idiosyncratic risks

The present study proposes a new evaluation approach aimed at estimating the cost of equity through standardized models which consider an innovative set of firm-specific information on the main unsystematic risks which are typical of any business. Our objective is extending the Capital Asset Pricing Model (CAPM) by defining a standard formula for quantifying the premium for certain idiosyncratic risks as a function of a new set of firm-specific quantitative information. We define two econometric models, for listed and non-listed firms respectively, which consider five idiosyncratic risk factors: firm size, value factor, operating risks, financial structure and stock market price volatility. The models were tested on a sample of European non-financial companies. The empirical results show that while the CAPM systematically underestimates the cost of equity, the proposed models correctly estimate its expected value; furthermore, they show a slight improvement also in terms of estimates’ volatility. Due to their efficacy and ease of use, the proposed models represent a valid practical tool for investors, analysts and professional evaluators. This work contributes to the existing literature by proposing a typologically innovative extension of the CAPM set of explanatory variables, defining and testing new models for the estimation of the unsystematic risks’ spread of the cost of equity based on an original set of firm-specific accounting and market information.     

The long-run equity risk premium

Based on a survey of US Chief Financial Officers (CFOs), we present expectations of the equity risk premium measured over a 10-year horizon relative to a 10-year US Treasury bond. This multi-year survey has been conducted each quarter from June 2000 to June 2005. Each quarter the survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. The individual uncertainty is deduced from the 80% confidence interval that each respondent provides for his or her risk premium assessment. We also present evidence on the determinants of the long-run risk premium. Our analysis suggests there is a positive correlation between the ex ante risk premium and real interest rates as reflected in Treasury Inflation Indexed Notes.     

Time Diversification: Empirical Tests

This paper investigates the relationship between the performance of equity and the length of the investment horizon used by investors. We examine optimal portfolio time diversification and two definitions of ex ante time diversification. Using almost two centuries of US and UK data we find some support for the hypothesis that equity represents a significantly better investment over long investment horizons than over short investment horizons. Where this result holds, the likely explanation is mean-aversion in fixed-income asset returns. However, these results are sensitive to changes in investor risk preference, changes in utility function specification, changes in the sample period used, changes in investor constraints, and the definition of time diversification adopted. They also differ between the US and UK markets.     

The expected value premium

Fama and French [2002. The equity premium. Journal of Finance 57, 637–659] estimate the equity premium using dividend growth rates to measure expected rates of capital gain. We apply their method to study the value premium. From 1945 to 2005, the expected value premium is on average 6.1% per annum, consisting of an expected dividend growth component of 4.4% and an expected dividend price ratio component of 1.7%. Unlike the equity premium, the value premium has been largely stable over the last half century.     

Life Insurer Cost of Equity with Asymmetric Risk Factors

This study presents an improved model for estimating life insurer cost of capital with the inclusion of upside and downside risk factors and controlling for life insurer characteristics. Although various asymmetric measures of market risk have been shown to be priced factors for the broader equity market, life insurer realized equity returns include a much larger premium for bearing downside risk, even after controlling for firm characteristics and other measures of risk. Cross‐sectional regression analysis finds a positive (negative) premium for downside (upside) betas, conditional on down and up markets, respectively. Coskewness and cokurtosis are also priced factors.     

Equity Premia as Low as Three Percent? Evidence from Analysts' Earnings Forecasts for Domestic and International Stock Markets

The returns earned by U.S. equities since 1926 exceed estimates derived from theory, from other periods and markets, and from surveys of institutional investors. Rather than examine historic experience, we estimate the equity premium from the discount rate that equates market valuations with prevailing expectations of future flows. The accounting flows we project are isomorphic to projected dividends but use more available information and narrow the range of reasonable growth rates. For each year between 1985 and 1998, we find that the equity premium is around three percent (or less) in the United States and five other markets.     

Disclosure Interactions and the Cost of Equity Capital: Evidence From the Spanish Continuous Market

Abstract:  The purpose of this paper is to provide some new evidence on the relationship between disclosure and the cost of equity capital. We propose a new specification for the empirical test based on the idea that in the previous models one crucial variable was missing: accounting policy choice. We test our theoretical hypothesis using a sample of Spanish firms quoted on the Spanish continuous market from 1999 to 2002. We adopt the ex-ante approach to measure the cost of equity capital, taking analysts predictions as a proxy for expected earnings. As an explanatory variable we use an index measuring annual report disclosure quality. This measure of disclosure is combined with a proxy for the accounting policy choice of the firm. We measure firms' conservatism using the modified Jones model of Dechow et al. (1995) to estimate discretionary accruals. Our results confirm that the relationship between disclosure and cost of capital is affected by the choice of accounting policy.     

Recognition versus Disclosure: An Investigation of the Impact on Equity Risk Using UK Operating Lease Disclosures

This study examines the equivalency of accounting recognition versus disclosure. OLS regression analysis is used to determine whether there is an association between equity risk and an adjustment to financial risk for off-balance sheet operating leases. Two methods of adjustment are considered: constructive capitalisation and a simple factor method. The observation of a reliably positive association suggests that UK investors/analysts view operating leases from a property rights perspective rather than an ownership perspective. This supports the argument for recognition of all lease rights and obligations 'on-balance sheet', as proposed in the recent G4+1 discussion paper ASB (1999).