Dear Reader, this is probably one of the oldest discussions out there but it is indeed a very interesting one. Should the Market Equity Risk premium have a term structure / be dynamic? I'd like to start out with two quotes:
Of all the potential problems in estimating implied cost of capital, the lack of constancy of the
discount rate is probably the most under-researched in the literature."
(Lambert, 2009, p. 2)
"In an environment that allows for time-varying discount rates, instead of a static implied cost
of equity, there is a term structure of implied costs of equity capital."
(Callen and Lyle, 2014, p. 9)
Nowadays a lot of static/ backward-looking methods (like the CAPM and its variations) are used to estimate the market equity risk by extrapolating long-term averages assuming that the future premium will revert to its historical mean. But are those averages actually a good predictor for a future risk premium? Should a backward-looking average include the 2008 crisis event? How far should we go back? If we go back too far to smoothen out the crisis, is this old data even relevant for today's risk premia? Should we use data post-2008 crisis or would our data suffer from an insufficient sample size? Is it appropriate to use only data from the US equity market which has been the most successful capital market worldwide? Do other equity markets have sufficient and reliable stock data?
I stumbled upon a quite creative approach by Callen and Lyle (2014) about the calculation of a term-structure of equity market risk. In this paper, they tried to estimate the term structure based on synthetic futures contracts using current put and call options.
That leads us back to the question: Should the Equity Market Risk Premium have a term structure? I look forward to your comments.