Why you’re mis-estimating the Equity Risk Premium #3

You’ve used the ‘wrong’ risk free rate

Your ERP estimate can be incorrect if you’re not applying it in the same manner in which you estimated it. This isn’t as much an issue of there being a ‘right’ risk-free rate, but we have to compare apples with apples.

The ERP estimated with risk-free as T-Bills or short term rates will be different from that estimated using long (10 year or longer) bonds as risk-free.

If we want the ERP to reflect the additional return for bearing equity risk only, then arguably it is better to compare it to a long government bond with more comparable term and liquidity rather than the very short-dated T-Bill.

When using the ERP in your valuations, you should be clear whether it is added to T-Bill or bond rates, and whether the liquidity and term characteristics of the cash flows are consistent with this choice.

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Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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