Estimating a market risk premium is challenging due to many reasons. None can predict the future! So we default to historical market risk premiums. Even when we agree that we can look to the past to arrive at an estimate of the market risk premium, there is significant disagreement on the time frame to be used. There is disagreement on the frequency to be used: daily, weekly? There is also disagreement on the method to be used: geometric average or arithmetic average as well as the market to be considered: US or London market or another one? Given these issues with market risk premium, do we have an alternative?
We look at an alternative to the historical market risk premium in this article.
An alternative to backward-looking historical risk premiums, we can look at the current market-implied risk premium. Today’s market price is theoretically arrived at by discounting expected cash flows which incorporate an expected risk premium. Therefore, using the market price and expected cash flows you can back out the implied expected risk premium.
The implied expected risk premium solves the backward-looking issue in the historical risk premium. However, the implied risk premium is constantly fluctuating, given the changing mood in the market. The implied risk premium has floated around 4% over the last 50 years.