The Dynamics of Equity Risk Premium : The case of France, Germany, Sweden, United Kingdom and USA

University essay from IHH, Economics, Finance and Statistics

Abstract: Equity risk premium is a financial variable that is surrounded by mystery. Starting from the almost 30 year old equity premium puzzle caused by considerations that equity premium values which are observable in past data imply an implausibly high risk aversion to more recent statements that equity premium does not exist anymore. The purpose of this paper is to find out more about the traits and characteristics of equity risk premium, its current status and interactions of its values across international markets by conducting data analysis on mature equity markets using optimal methods as suggested in academic literature. This paper attempts to clear some of the confusion regarding equity premiums by analyzing equity excess returns in the mature equity markets of France, Germany, Sweden, United Kingdom and USA from 1970 to 2012. It is concluded that equity premium follows a mean reverting process however in short-term and mid-term its values can be volatile and in March 2000 there might have been a structural break. The obtained current equity premium values are significantly higher than zero. At the same time they are lower than popularly used values that are based on longer periods of past data. The paper also finds out that equity premiums in different countries are highly correlated not only due to shared global influence but also due to some direct causality relationships between them, most of which are positive. A panel data analysis is conducted as well to test the explanatory power of some macroeconomic and financial variables on the equity risk premium values and it is concluded that risk-free rate and unemployment rate have some explanatory power for equity risk premium values. This paper manages to clear a part of the mystery that surrounds the equity risk premium.

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