Equity Risk Premium: Expectations Great and Small

1. Equity Risk Premium: Expectations Great and Small Richard A. Derrig and Elisha D. Orr Bowles Symposium April 2003

2. Equity Risk Premium (ERP) • Definition: Difference between the market return and a risk-free return

3. US Equity Risk Premia S&P 500 1926-2002 Source: Ibbotson Yearbook (2002) and December 2002 Market Report

4. Why the ERP is Important for Actuaries ? • Universally accepted benchmark for pricing risk • Input into simple CAPM and Fama-French 3-factor model • Affects other cost of capital estimates and discount rates • Market value of liabilities

5. Paper Objectives • Introduction to the ERP Puzzle • Types of ERP • Time Series Analysis • Catalogue ERP Puzzle Literature • Selection of an ERP • Summary

6. ERP Puzzle • Mehra and Prescott (1985): • Anomalous results when historical realized ERP compared to asset pricing theory values • Otherwise, must assume risk aversion level outside of “reasonable” range • Led to literature to solve the “ERP puzzle”

7. Literature to Solve the Puzzle • 1st thread (Behavioral Finance) • New models and assumptions to explain historical data • 2nd thread • Estimates of the ERP from standard economic models • Catalogue in Appendix B

8. ERP Types • Geometric vs. arithmetic • Short vs. long investment horizon • Short vs. long run expectation • Unconditional vs. conditional • US vs. international market data • Data sources and periods • Real vs. nominal returns

9. ERP using same historical data (1926-2002) Source: Ibbotson Yearbook (2002) and December 2002 Market Report

10. Converting from Geometric to Arithmetic Returns • Formula: AR = GR + var/2, var, variance of the return process

11. Time Series Analysis • Stationarity Assumption • Supported by ANOVA regressions • ARIMA model projects future years as average of data • No significant time trends • Mean of full Ibbotson series and subset (1960+) not statistically different

12. Why Different Estimates ? • Historical • 1926-2002 • 1802-2001 (Earlier period) • Dividend Growth Model • Next Ten Years + Remainder of 75 Years • Historical ≠ Expected • Conditional versus Unconditional expectations

13. Short-Horizon ERP bySub-periods Source: Siegel (1994)

14. Catalogue of ERP Estimates • Social Security (1999, 2001) • Puzzle Research • Campbell and Shiller (2001) • Arnott and Ryan (2001), Arnott and Bernstein (2002) • Fama and French (2002) • Ibbotson and Chen (2003) • Constantinides (2002)

15. Catalogue of ERP Estimates (Cont.) • Financial Analyst Estimates • Claus and Thomas (2001) • Harris and Marston (2001) • Surveys • CFOs, Graham and Harvey (2002) • Financial economists, Welch (2000 & 2001) • Behavioral Approach

16. The Next 10 Years • Social Security • Lower return over next 10 years • Remainder of 75 years likely to be similar to historical returns • Campbell and Shiller • Current P/E and Div/P ratios far from mean • With mean reversion assumption, dismal forecast for next ten years • Market decrease since 1999 is -37.6% or -14.6% annual

17. TIPSInflation-Indexed Treasury Securities Source: WSJ 2/24/2003

18. Behavioral Finance • Benartzi and Thaler (1995) • Start with prospect theory • Loss Aversion • Add “mental accounting” • Myopic Loss Aversion

19. Selecting an ERP • Rely on past data to forecast the future OR • Analyze the past and apply informed judgment as to future differences

20. What You Need To Know About ERP Estimates • Range of estimates • Appendix B • Data and terminology • Underlying assumptions • Your independent analysis is required if estimate differs from historical average

21. Where to Go From Here • Ibbotson and Chen (2003) • Appendix C • Fundamental components of the historical ERP • Change estimates based upon good judgment • The puzzle is not yet solved…