The Equity Premium – a Coronavirus-Puzzle!
Preface: I know that there are some readers who are mainly interested in accounting topics. And those will be served by this post, too, as the equity premium is also a very hot topic in accounting these days. But for getting there, you have to read through till the end… ?
Furthermore, this blog post serves as an add-on to our former post on the cost of capital during the coronavirus crisis (HERE)
In 1985 Rajnish Mehra and Edward Prescott shocked the financial academic community with their article “The Equity Premium: A Puzzle” ( Journal of Monetary Economics, 15 (2), pp. 145-162). Until then, the level of equity risk premia could more or less be explained by the volatility of stock market returns if one assumes a quite reasonable degree of risk aversion. However, Mehra/Prescott stressed that it is not stock prices that matter for deriving utility functions of individuals but rather consumption – and consumption volatility is much lower than equity volatility. And if we substitute stock market volatility by historical consumption volatility in our explanatory model, we would end up with a reasonable equity risk premium of about 0.2 to 0.4 percent. This is lower roughly by the factor 25 than what academics and investors saw as reasonable at that time or could measure from past data (ca. 7.5%).
Today, we have several explanations for this equity premium puzzle (although not everything can be explained). And hence we again feel quite comfortable to look at the stock market when trying to derive equity risk premia – in particular if it is about practical valuation cases. However, the massive distortions that the coronavirus-crisis brought to international stock markets has raised again lots of questions what this development means for the equity premium. And this is not only a question that serveral investors ask, to find a good answer is also of utmost importance for auditors these days – because 31 March 2020 is the big Q1/2020-impairment testing reference date! This is why, in this blog post, we provide a bit of background on how to find out where equity risk premia have gone in the last weeks, and on why perhaps not everybody is happy with this development.
Starting point is to look at what the equity premium actually is, and how the current coronavirus-crisis has impacted it.
What is the Equity (Risk) Premium?
The Equity Premium is the percentage premium that investors require (over and above the risk-free rate) for taking stock market risk. It is a forward-looking measure and it depends on two factors: first, the degree of risk aversion of average market participants – the higher the risk aversion, the more premium is required for a given amount of risk. And second, the riskiness of the stock market (assuming that stock market risk is relevant here, and not consumption risk as Mehra/Prescott stated).
Assuming that the general risk aversion has not changed (or at least not decreased) in recent weeks, the equity premium should have increased recently as – and there should be no major doubt about it – the uncertainty of the stock market has massively increased.