eThesis - School of Business electronic theses

The main objective of the study is to determine the level of implied equity risk premiums from two models and to analyse their explanatory power in terms of future realized equity risk premiums. The paper studies a new method to estimate implied premiums and validates the results by a comparison to an established model. Luoma and Sahlström (2009) presented their model to estimate implied equity risk premiums by looking at an earn back period calculated from analysts' earnings forecasts, the current market price and the risk-free rate. Their model has not been empirically tested before. To evaluate the validity of the numbers obtained from their model, a similar test is executed employing an established model presented by Claus and Thomas (2001) that estimates implied premiums by using book values and earnings forecasts.

The sample firms are constituents of the S&P 500 index that is based on the market capitalizations of 500 largest companies publicly traded in the U.S. stock market. The dataset consist of a sample of 6710 firm-year observations including 824 different firms during 1985 to 2010. Using the firm-year observations, implied equity risk premiums are calculated for the two models. To gain understanding on the explanatory power of the two methods in terms of future realized equity risk premium, cross-correlations and regressions are built. A self-financing trading strategy is employed to determine the economic significance of the implied equity risk premium.

I find that the implied equity risk premiums from the two models are below the historical equity risk premium estimates. Implied equity risk premium from Luoma-Sahlström model is 2.35 percent. Implied premium obtained from the Claus-Thomas model is 4.56 percent. Analysis shows that the both models have statistically significant explanatory power. There is a positive link between implied premiums and future realized equity premiums. The significance is stronger in the Luoma-Sahlström model. A self-financing trading strategy built to capitalize on the explanatory power shows that portfolios containing stocks with a high level of implied equity risk premium outperform the portfolios containing stocks with a low level of implied equity risk premium by 2.0 percent. This shows that the implied equity risk premium models have economic significance and provide interesting trading opportunities.