Content area
Full Text
Abstract This paper investigates the behaviour of risk premiums of European stocks. It is found that risk premiums deviate significantly from their equilibrium level. Over time, however, they revert to their equilibrium level. This reversion can be exploited in an active stock selection strategy. Compared with a passive investment, such a strategy yields a risk adjusted excess return of more than 8 per cent p.a. for a medium level of risk (ie 6 per cent tracking error).
Keywords: risk premium, mean reversion, market efficiency, active portfolio management
Introduction
The equity risk premium is one of the most important measures in financial economics. It represents the excess return over the risk-free rate an investor can expect for a period of time. In practice, the equity risk premium is unobservable. There are two fundamentally different methods of estimating the risk premium. First, an investor can use observable market prices and apply some statistics to deduce an estimate. This method will be referred to as the implied risk premium, as it is implied by the market price. Secondly, an investor can apply financial theory and assume that the market is in equilibrium. This method will be referred to as the equilibrium risk premium.
Comparing the implied risk premium with the equilibrium risk premium offers a way of assessing whether market prices are too high or too low. This can be done for the stock market in general or for single securities. Mehra and Prescott (1985) investigated the equity risk premium of the US stock market. Their result led to the equity risk premium puzzle. They argued that the risk premium implied by US stock prices cannot be explained by the equilibrium model of Lucas (1978). Alternative models have been developed to explain this puzzle.1 This paper is concerned with the equity risk premium of single stocks. If the implied risk premium is above the equilibrium rate, the stock's expected return is too high, given its risk. As a result, market prices are too low. If the implied risk premium is below the equilibrium rate, return expectations are too low and, hence, prices are too high. Comparing the implied risk premium with the equilibrium risk premiums can possibly be exploited by an investment strategy, ie buying undervalued...