Interest Rate Dynamics and the Equity Risk Premium
The Market Risk Premium and Its Relationship to Interest Rates
The equity market risk premium is a fundamental concept in finance, playing a crucial role in investors’ asset allocation decisions, corporate capital budgeting, and regulated industries’ pricing frameworks. Beyond its practical applications, estimates of the market risk premium also provide insight into potential market overvaluation and financial stability. Despite its significance, measuring the market risk premium—both its level and its dynamics—remains a challenge.
Historically, the average of realized excess returns has exceeded the levels implied by standard economic models, giving rise to a long-standing debate in academic research. While the precise level of the market risk premium remains unresolved, recent studies have shifted their focus to its dynamics, particularly its relationship with the risk-free interest rate. This question is of particular importance, yet empirical findings remain inconclusive. Most studies rely on stock-bond correlations or short-term return predictability, yet they provide limited evidence on the ex-ante risk premium’s evolution over time. Moreover, existing theoretical frameworks offer little guidance on the expected sign or magnitude of this relationship.
Research Objective
This project seeks to address the central question:
How does the market risk premium relate to the level of interest rates?
Since the ex-ante market risk premium is unobservable, researchers have developed various estimation techniques. One widely used approach relies on long-run historical averages of realized excess returns, serving as a proxy for expected risk premia. However, this method may not capture time-variation in expected returns.
An alternative approach leverages option-implied variance (SVIX) to infer risk premia from market expectations. While promising, this method faces challenges due to the limited availability of historical options data and its reliance on option market liquidity and efficiency. As a result, empirical applications of SVIX are largely restricted to post-1990s data.
Another strand of research employs factor models and firm characteristics to estimate expected returns. However, these methods are often subject to data mining concerns and poor out-of-sample performance.
Methodology and Contribution
This project focuses on estimating the market risk premium using the implied cost of capital (ICC)—a forward-looking measure derived from market prices and expected future cash flows. ICC is defined as the discount rate that equates the present value of expected future earnings to the current stock price, effectively capturing investors' required return on equity. Unlike realized returns, which are backward-looking, ICC provides an ex-ante measure of expected returns based on firm fundamentals. By comparing ICC-based estimates with other methodologies, we aim to assess the robustness of different approaches and explore their connection to interest rate dynamics.
Through this analysis, we aim to clarify the economic forces driving equity market risk premia, offering new insights into risk pricing, market efficiency, and the interaction between equity returns and macroeconomic conditions. By systematically comparing different estimation approaches, we provide a more rigorous framework for understanding how the market risk premium evolves in response to changes in interest rates and economic fundamentals.
The presentation providing an overview of expected equity risk premia is available here.
Project team
o.Univ.Prof. Dr. Josef Zechner
Univ.Prof. Dr. Otto Randl
