Equity Premium_discussion - Research Roundtable The Equity Premium By IVO WELCH Yale School of Management Yale University [email protected] Yale

Equity Premium_discussion - Research Roundtable The Equity...

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Research RoundtableThe Equity PremiumBy:IVO WELCHYale School of ManagementYale UniversityEmail[email protected]Postal:Yale UniversityYale School of Management46 Hillhouse Ave.New Haven, CT 06520Phone:(203) 436-0777Fax:(203) 436-0779Organized by PETER TUFANOHarvard Business SchoolHarvard UniversityDiscussantsPETER BOSSAERTS, California Institute of TechnologyJOHN COCHRANE, University of Chicago, Graduate School of BusinessGENE FAMA, University of Chicago, Graduate School of BusinessWILL GOETZMANN, Yale University, School of ManagementROBERT S. HARRIS, Darden Graduate School of Business, University of VirginiaJOHN HEATON, Northwestern University, Kellogg Graduate School of ManagementROGER IBBOTSON, Yale University, School of ManagementMICHAEL J. MAUBOUSSIN, Chief U.S. Investment Strategist - Credit Suisse First Boston andAdjunct Professor - Finance and Economics -Columbia Business SchoolANDRE F. PEROLD, Harvard University, Harvard Business SchoolJAY RITTER, University of Florida, Warrington College of BusinessROBERT WHITELAW, New York University, Stern School of BusinessDiscussion board available at: Document:Available from SSRN Electronic Paper Collection:Date:June 30, 2000I. A BRIEF INTRODUCTION TO THE EQUITY PREMIUMII. SELECTED BIBLIOGRAPHYIII. COMMENTS BY DISCUSSANTSIV. BULLETIN BOARD FOR DISCUSSION OF THE EQUITY PREMIUM
I. A BRIEF INTRODUCTION TO THE EQUITY PREMIUMLoosely speaking, the equity premium is the difference between the return on risky stocks andreturn on safe bonds. It is the prime input both in the CAPM (the model used by mostpractitioners in computing an appropriate hurdle rate), and in asset allocation decisions (thechoice of whether an investor should hold stocks or bonds).Unfortunately, there is no universally accepted definition of the equity premium. In particular, onecan compute equity premia using different stock market indices, different bonds (either long-termor short-term), different methods of compounding or cumulating returns over time, and differenthistorical time periods. Such computational differences can lead to valid historical equitypremium quotations ranging from 4.3% per year up to about 9.4% per year, depending also onthe time period quoted (e.g., Welch [2000]). It is important for a user of equity premium estimatesto be clear about which definition is used and why it is the appropriate definition for the particularpurpose it is used for.There are three inter-related questions of primary interest to researchers:[1] Why has the historical equity premium been so high?[2] What is a good forward-looking prediction for the equity premium for the long run?[3] Can one use other variables, such as dividend yields, to come up with a good forecast of theequity premium, at least over a 1-5 year period?

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