Abstract
The concept of an equity risk premium (ERP) is fundamental to modern financial theory and central to every decision at the heart of corporate finance. Efforts to quantify ERP are well rewarded by insights into the stability and dynamics of long-term investment performance. Such efforts require the quantification of both historically realised (ex post) and expected future (ex ante) premiums. Finding an appropriate proxy for the expected (ex ante) ERP remains a challenging aspect. One widely used application is the use of long-term averages of observed market premiums as a proxy for expected returns. The aim of this paper is to analyse the appropriateness of the historical methodology of estimating expected ERP in the South African context. The analysis in this paper suggests that analysing past historical figures remains useful in the SA context. This is supported by the results of the statistical analysis, showing stationarity of the ERP time-series, meaning that the true mean does not change over time. This implies that the historical average mean may be used as a proxy for the long-run expected ERP. However, the well-documented problems relating to large standard errors (predictability problem) and relevance due to changing circumstances are also evident in the SA data. Thus, investors would be well advised to analyse the past and apply informed judgments as to future differences, if any, when attempting to arrive at fair forecasts.
Highlights
The concept of an equity risk premium ( ERP), the incremental return of certain equity market components relative to certain fixed-income components, is fundamental to modern financial theory and central to every decision at the heart of corporate finance
One possible and widely used application is the use of long-term averages of observed market premiums as a proxy for expected returns
It is often argued that the use of realised equity premiums as a proxy for the expected equity premium implicitly assumes stationarity of ERP, i.e. the true mean does not change with time
Summary
The concept of an equity risk premium ( ERP), the incremental return of certain equity market components relative to certain fixed-income components (usually bonds), is fundamental to modern financial theory and central to every decision at the heart of corporate finance. One possible and widely used application is the use of long-term averages of observed market premiums as a proxy for expected returns This is still widely used and advocated in leading textbooks, alternative approaches have emerged recently. A related concern is the fact that most emerging markets are re-emerging markets, potentially resulting in an overly optimistic picture of future returns by looking at historically realised returns Another problem is that the risk premium of an emerging market may change over time, as its degree of integration into world capital markets changes, as is widely recognised in the literature. The aim of this paper is to complement and extend the existing ERP literature, by analysing the SA experience - the appropriateness of the historical methodology of estimating future expected ERP in the South African context In this regard, the literature and available empirical evidence is reviewed. Results from existing studies are extended and complemented by extending the sample period and analysis of available data
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