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Equity Risk Premium and Investors Preferences Towards Reward-to-Risk from Europe, USA, and Asia

Multinational Finance Journal, 2020, vol. 24, no. 1/2, pp. 39-64
Pedro Pimentel , University of Azores, Portugal
Ana Cunha , University of Azores, Portugal

Abstract:
The equity risk premium is key for the cost of capital and a crucial tool to guide investment decisions. In the literature, an ex-post approach is widely used to estimate equity risk premium investor's future claims. In this paper, Merton's framework (1980) is applied to the Eurozone, USA, and Asia, using historical data for the period between 2002 and 2015. The expected equity risk premium will be calculated in the context of the financial crisis that started in 2008 and will be testing the reward-to-risk ratio non-negativity constraint. For all three economic areas, empirical analyses suggest investors' aggregate risk preferences that are stable for measurable periods. The authors subscribe to a direct connection between the time under analysis and the accuracy of equity risk premium estimates. At best, it is expected that equity risk premium for the Eurozone, USA, and Asia stand at 5.04%, 4.91%, and 7.75%, respectively.

Keywords : equity; risk; premium; preferences; volatility
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