ESTIMATING THE EQUITY RISK PREMIUM FROM DOWNSIDE PROBABILITY

Probability of downside risk tolerable by an investor would give an estimate of the ex ante equity risk premium over the bond yield, assuming that equity returns are lognormal random variables. Aggregate investors bring forth the market risk premium at equilibrium through the dynamic adjustment of bond yields and dividend yields. The model the author develops is applied to historical data to provide estimates of the equity risk premium over the last fifty-seven years. Analyzing historical relationships among the components of expected return (risk premium, dividend yield and expected growth rate, and bond yield) provides useful information for active asset allocation decisions.