Saturday, September 20, 2008

The key number for stocks: The Equity Risk Premium (ERP)

If there is one number that captures what the market mood is right now and how investors feel about equities collectively, it is the equity risk premium (ERP), i.e. the additional return that investor are charging for buying equities instead of putting their money into treasuries. The equity risk premium reflects the tug-of-war between hope and fear that equity investors bring to the market, and will vary on a day-to-day basis. As investors become more risk averse, they will a higher equity risk premium, which should translate into lower stock prices.
Last week provided a laboratory to observe movements in both direction in the equity risk premium. We started Monday morning (9/15/2008) with the S&P 500 at 1250 and the equity risk premium at 4.54%, but here is what happened over the week:
9/15/2008 (End of day): S&P 500 = 1193 ; ERP = 4.75% ; Fear rules (Lehman down)
9/16/2008 (End of day): S&P 500 = 1214; ERP = 4.67% ; Recovery (Hope for AIG/)
9/17/2008 (End of day): S&P 500 = 1156 ; ERP = 4.90%; Sheer, unadulterated Panic... 
9/18/2008 (End of day): S&P 500 = 1207; ERP = 4.70%; The world did not end!!!!
9/19/2008 (End of day): S&P 500 = 1255; ERP = 4.52%: Euphoria!!!
Now, that was a week for the history books!!!!
If you are wondering how I came up with these numbers, I won't bore you with the details here but you can download a paper on the topic on my website at
Check under research/papers! I would love to have your comments!


3 comments:

joeschmoed said...

How can we be sure that what is changing is the equity risk premium? Is it not just as possible that expectations about future earnings/dividend growth are what is causing the changes in the value of the index?

It would seem difficult to separate which side of the equation is causing the change in value, cash flow expectations or required returns.

Henry Bee said...

Hello Aswath,

Henry from SFU here. I've perused over your paper on ERP and absolutely loved it. It leaves open for so much possibility for further development. I am already working on an optimal portfolio allocation system using on your implied ERP with the Kelly Criterion. This is made possible because of market-based measures of risk and return (implied volatility from options for risk and implied ERP for return).

I have one question. Where did you obtain the data for buybacks. I've searched around for hours and couldn't find it. My email is hbee@sfu.ca

Mark said...

Hello Prof. Damodaran,

I've read parts of your paper on equity risk premiums, there, you said that it was no good to apply risk on the cash flow (using $90 with 100% prob = expected value of 90% of $100 and 10% of $0), however, what about applying risk in a scenario-type of valuation, where the cash flow is discounted only at risk-free rate and the valuation would have several results (in the case above, the discounted value of $90 and the discounted value of $0?

Won't the user of the valuation result be more aware of the fluctuations in cash-flow and able to ask a premium accordingly, rather than adjusting the premium in the discount rate?

because using the implied risk premium, forgive me if I'm wrong, would result in fluctuating risk premium, shouldn't risk premium be stable because we are discounting to eternity?

thanks