EQUITY RISK PREMIUM: EXPECTATIONS GREAT AND SMALL

North American Actuarial Journal,  Jan 2004  by Derrig, Richard A,  Orr, Elisha D

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Although both groups have made substantial and provocative contributions, the behavioral models do not give any eac rmfe ERP estimates other than explaining and supporting the historical returns. We presume, until results show otherwise, that the behaviorists support the historical average as the e% ante unconditional long-run expectation. Therefore, we focus on the latter to catalogue ERP estimates other than those based on the historical approach,4 hut we will discuss both as important strains for puzzle research.

3. ERP TYPES

Many different types of ERP estimates can he given, even though they are labeled by the same general term. These estimates vary widely; currently the estimates range from about 9% to a small negative. When ERP estimates are given, one should determine the type before comparing to other estimates. Here are seven important types to look for when given an ERP estimate:

* Geometric versus arithmetic averaging.

* Short versus long investment horizon.

* Short- versus long-run expectation.

* Unconditional versus conditional on some related variable.

* Domestic United States versus international market data.

* Data sources and periods.

* Real versus nominal returns.

A second important difference in ERP estimate types is the horizon. The horizon indicates the total investment or planning period under consideration. For estimation purposes, the horizon relates to the term or maturity of the risk-free instrument that is used to determine the BRP. Ihhotson Associates (2003a, p. 177) provides definitions for three different horizons. The short-horizon expected ERP is denned as "the large company stock total returns minus U.S. Treasury bill totoZ returns." Note, the income return and total return are the same for U.S. Treasury hills. The intermediate-horizon expected ERP is "the large company stock total returns minus intermediate-term government bond mcome returns." Finally, the long-honizon expected ERP is "the large company stock total returns minus long-term government bond mcome returns." (Table 1 displays the short-horizon ERP.)

For the Ibbotson data, Treasury bills have a maturity of approximately one month, intermediate-term government bonds have a maturity around nve years, and long-term government bonds have a maturity of about 20 years. Although the Ibbotson definitions may not apply to other research, we will classify ERP estimates based on these guidelines to establish some consistency among the current research. The reader should note that Ibbotson Associates recommends the income return (or the yield) when using a bond as the risk-free rate rather than the total return.7

A third type is the length of time of the KRP forecast. We distinguish between short-run and long-run expectations. Short-run expectations refer to the current ERP or, for this paper, a prediction of up to 10 years. In contrast, the long-rtm expectation is a forecast over K) years to as many as 75 years for social security purposes. Ten years appears an appropriate breaking point based on the current literature surveyed.