The CAPM Market Risk Premium is Forward-Looking

Inflation, Real GDP, Stock Market Volatility and Term Spread

Shakespeare wrote, “Whereof what’s past is prologue; what to come, in yours and my discharge.”

Indeed, the past does not determine the future, not even for stock returns and the market risk premium. The Securities Exchange Commission requires mutual fund prospectuses to include the caveat that a fund’s past performance does not necessarily predict future results. Yet, largely due to the paucity of forward-looking equity return data, realized (historical) stock returns are frequently used to estimate the market risk premium, a key input of the widely used Capital Asset Pricing Model (CAPM) valuation tool.

The CAPM is used to estimate the cost of equity component of a firm’s cost of capital which is used in corporate finance, investment portfolio development, and regulatory rate proceedings. The model’s market risk premium component equals investors’ expected return on the market less the risk-free rate and, thus, should be forward looking. Using a historical market risk premium is unlikely to reflect return expectations of investors, which can lead to inaccurate results with costly implications for investment decisions and public utility customers’ rates. Nevertheless, historical market risk premiums are frequently used to estimate the market risk premium in CAPM analyses because calculating the average realized market risk premium based on historical stock returns is fairly easy given the relatively wide availability of stock return data. The opposite is true for determining the forward-looking market risk premium which reflects investors’ unobservable expectational return on the market portfolio of aggregate wealth.

One of the main contributions to our white paper “Forward-Looking Market Risk Premiums (1992-2020) and Macroeconomic Factors: Inflation, Real GDP, Stock Market Volatility and Term Spread” is the use of an expectational market return to estimate the forward-looking (ex ante) market risk premium at the end of each quarter over a 29-year period through 2020. Investors’ expected returns were estimated using the Discounted Cash Flow (DCF) model applied to all dividend-paying companies of the S&P 500 quarterly from 1992-2020 using consensus financial analyst growth forecasts, and from which the contemporaneous 20-year Treasury bond yield was subtracted to estimate the forward-looking market risk premium at each quarter-end. We compare these ex ante market risk premia to historical (ex post) market risk premia and find that, while larger, the forward-looking market risk premia are more stable with lower standard deviations than ex post market risk premia regardless of time horizon. We also examine the relationship of the ex ante market risk premium to various macroeconomic factors that other studies have examined often with ex post equity risk premia. This paper additionally examines forecasted inflation and forecasted GDP growth relative to the ex ante market risk premium as prior studies have focused more on actual inflation and actual GDP growth. We find that during the 1992 to 2020 period, the ex ante market risk premium has (1) a statistically significant strong negative correlation to long-term government bond yields, (2) a statistically significant strong negative correlation to expected inflation (both for 5-year and 30-year forecast horizons), (3) a statistically significant positive correlation to stock market volatility, and (4) no strong correlation with actual inflation, actual GDP, forecasted GDP, or the term spread.

Ms. Nicdao-Cuyugan is the Director of Utility Research & Analytics at the Illinois Commerce Commission (ICC) and Ms. Phipps is the Assistant Director of the ICC’s Financial Analysis Division. The views and opinions expressed in this paper are those of the authors and do not purport to represent the position(s) of the ICC.