Date of Award

Spring 2016

Document Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Department

Finance

Committee Director

Mohammad Najand

Committee Member

John M. Griffith

Committee Member

Licheng Sun

Committee Member

Vinod Agarwal

Abstract

The equity risk premium (ERP) is an essential component of any asset pricing model both for academics and practitioners alike. Nevertheless, the financial literature does not accord much attention to the ERP estimation issues (Damodaran, 2015). The first chapter of this dissertation gives a summary of the recent literature review on the subject of the ERP. The second chapter explores four of the most commonly cited models in literature for estimating the ERP: the Historical Mean of Realized Returns Model (HMRRM), the Dividend Discount Model (DDM), the Free Cash Flow Model (FCFM), and the Sharpe Ratio Model (SRM). The results indicate that the estimates of the ERP vary considerably depending on (a) the variable of choice for the risk free rate; (b) the selection and the length of the estimation period; (c) and the estimation method. The DDM and the FCFM produce estimates for the implied ERP that are below the historical estimates, while the SRM produces implied ERP values that are usually higher than the historical values of the ERP. The post 2008 financial crisis period produces estimates for the historical ERP that are slightly higher or lower than the implied ERP estimates for the FCFM. The implied ERP estimates for the three models are more volatile than the historical ERP. In particular, estimates of the implied ERP from the SRM tend to overshoot the historical ERP estimates during periods of high volatility and fall below the historical level during periods of low stock market volatility.

The third chapter explores the relationship between the expected ERP and macroeconomic variables. The results from the four OLS regressions indicate that the relationship between the expected ERP and the unexpected inflation volatility is in general negative and insignificant even after accounting for recessionary periods. The results validate the Proxy Hypothesis theory of Fama. On the other hand, the expected ERP is found to be positively correlated with the stock market volatility in times of non-recessionary periods but negatively correlated in times of recessionary periods.

ISBN

9781339893235

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