Estimating the Equity Risk Premium and Expected Equity Rates of Return: The Case of Canada

15 Pages Posted: 14 May 2019

See all articles by Laurence David Booth

Laurence David Booth

University of Toronto - Rotman School of Management

Date Written: Winter 2019

Abstract

It is common to use the average excess return of equities over bonds estimated over long time periods as an expected equity risk premium on the grounds that going back far enough covers most possible economic scenarios. But although this data is useful in guiding the exercise of judgment, it cannot substitute for judgment. Adding more years of data to the near century of Canadian stock and bond returns that inform today's estimate of the equity risk premium will not produce a “random walk” for a simple reason: the historic bond series is the result of a specific historic monetary policy. This is particularly true of and important for the case of Canada, where today's very low current bond yields reflect the emergence of the Canadian dollar as a reserve currency as well as the impact of unconventional monetary policy elsewhere. After analyzing the historic record of the Canadian equity risk premium and noting the need for adjustments when this premium is applied to the current anomalously low Canadian long‐term bond yields, the author reaches the following conclusions:. In sum, the conventional practice of adding a historic market risk premium to the current low Canada long bond yields would impart a sharp downward bias to current equity cost estimates; use of this method would not be appropriate until long Canada bond yields increase to at least the 4.0% level.

Suggested Citation

Booth, Laurence David, Estimating the Equity Risk Premium and Expected Equity Rates of Return: The Case of Canada (Winter 2019). Journal of Applied Corporate Finance, Vol. 31, Issue 1, pp. 113-125, 2019, Available at SSRN: https://ssrn.com/abstract=3388238 or http://dx.doi.org/10.1111/jacf.12333

Laurence David Booth (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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