Equity Premium Research

Equity Risk Premium,also named as Equity Premium hereinafter,whose abbreviation is ERP,which means the difference of earning ratio between common equity and free-risk securities(i.e.government bonds).John Miller was the first one using the concept of ERP.We can find the expression in his works in 1848.Following is how he described a farmer decided to invest on the land:(...he will probably be willing to expand capital on it(for an immediate return) in any manner which afford him a surplus profit,however small,beyond the value of the risk,and the interest which he must pay for the capital if borrowed,or can get for it elsewhere if it is his own)Miller divided the profit into three parts:one was the interest rate of a loan.This can also be named as the opportunity cost of the capital.The part nearly amounted to free-risk interest rate;the second part was price of risks related to the investment.In fact,this is something like equity premium;the third part was surplus profit.To state it in modern finance language,that is "a"——the surplus profit can be got in a wholly competitive market.After Miller,in his article(Risk,Uncertainty and Profit),Kinght reviewed all of the documents before 1920 that discussed about the composition of profit,analyzed the all of the statements of risk,and pointed out the insufficiency of them.None of the documents told us the difference between measurable risk and immeasurable risk.Knight defined the latter as uncertainty and he believed that both risks should be compensated.Moreover, Knight discovered the substance of equity premium——surplus compensation brought by measurable uncertainty.It is obvious that the equity return of long-time invest regressed to the mean value. Taking the US market as an example,and one year as the comparative period,the ERP fluctuation ratio was 20%;if taking ten years as the comparative period,the fluctuation ratio sharply dropped to 6%;if we look into the performance of the main stock markets in the world from 1900 to 2005,we can find the ERP showed great stability during the one-hundred-long period.The significances of ERP research are as followings.1.ERP is the fundamental factor in asset allocation decision.The investors will consider various risk assets,expect profit ratio of free-risk capital and invest risk before the asset allocation decision-making.This is specially important to those long-term investors(like social insurance fund in China). 2.Equity premium is the key factor to the project investment.It is the basic variable of some modern asset-pricing model,like CAPM.3.It decides the stock price.It is must-know variable for security analysts and bankers,because it is necessary to use ERP to estimate the rational PE ratio,to forecast the price when they apply DCF,DDM models.4.Equity premium,especially short-time ERP is changing.Why it changes? The economics research tell us those basic economic variables as population,policy and the growth-way of economy have substantial influence on the transformation of financial market.This thesis is composed of seven chapters.The first chapter is introduction,in which I set forth the origin of ERP and the significance of the research.In the second part,we list the research of econometrics on ERP.From the middle of 19 century,econometricians first notified ERP.Roger Ibboston and Rex Sinquefield published . And they set the original standard for calculating ERP.Then,William Goetzmann,Roger Ibbotson and Liang Pang published .They expanded the time-span from 46 years to 160 years.Roger Ibboston and Carol Fall published a report named < The United States Market Wealth Portfolio:Components of Capital Market Values and Returns,1947-1978>. They took other U.S.securities,commercial real estate and farm land under survey.They estimated the premium of stock to other assets.Moreover,the article < World Wealth:U.S and Foreign Market Values and Returns > written by Roger Ibboston,Laurence Siegel, Kathryn Love,took the asset all around the world into consideration,and made comparison of the return ratio between the US and other countries.In the third chapter,we recite the quantitative researches of ERP by Chinese economists.After the brief review,we take the investment of all-tradable share as the object to estimate the equity premium.Taking the data from 1993 to 2007 as sample,the arithmetical means of ERP of Chinese A-share market is 15.29%,and geometric mean is 4.59%.Next,we extend the research into all of the security businesses.And we find the ERP has a sharply increase,the arithmetical means rise to 25.46%,and the geometric mean reaches 13.8%.At last,we spread the research scope to bonds,mutual funds and real estate e.t..and compare the return rate of stock with other finance asset,we arrive at a ERP in a broader sense.The fourth chapter is the summarization of nine questionnaire we made in practices, from which we conclude the investors' risk preference in Chinese stock marker and the changing of implied equity risk premium.In the fifth chapter,we set out from Implied Equity Risk Premium,look into the factors that affect ERP.From the view of finance,we believe factors such as macro economy, industry profit,and market system influence the ERP.In the part,we quantificationally analyze the variables as macro economy and increasing rate of industry profit,and qualitatively explain how the appreciation of RMB affect short-term stock market in China.In the sixth chapter,we state the famous "Equity Premium Puzzle".The Puzzle was put forward by Mehra Prescott in 1985,and it triggered a huge sub-branch.Based on the maximization of trans-period investment-consumption utility,the microeconomics made use of behavior finance theory to re-explain the finance in a macro-way,and developed a serial of behavior capital pricing model.We also discuss the Equity Premium Puzzle in China,and give a possible explanation.In the last chapter,we focus on the effect that none-tradable-share reform have on the ERP,make quantitative analysis on its effect and qualitative analysis on its far-reaching significance.