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Monitoring the equity risk premium in the S&P500

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This article uses a structural contingent claims model based on free cash flows to equity (FCFE) to derive the equity risk premium implicit in S&P500 stocks. This is done at the aggregate level for the period between 1999 and 2017. The results obtained are compared with those that come out from the traditional single-stage FCFE model. Two assumptions regarding long-term corporate growth expectations are made leading to slightly different results. Setting cash flow growth expectations based on 30-year U.S. bond yields the equity risk premium in December 2017 is found to be 4.6%, very close to the minimum value of the series. When a multiple of analysts forecasts on corporate 3 to 5-year earnings growth is used, the equity risk premium is found to be 5.2%, somewhat closer to the average equity risk premium estimated, which is approximatelly 5.9% in both cases. Under both cases the implied equity risk premium is found to be currently on a downward trend. The higher equity risk premium obtained in the second case is justified by the recent decoupling between analysts forecasts and the long-term risk free rate. This can be the result of analysts optimism on future firm performance but can also be related with the current abnormally low level of long-term interest rates.
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