Equity Risk Premium Model
Latest Update: July 31, 2019
Updated by: John Moschella
Model Summary: This model uses the Fed Funds rate, 10-year U.S. Treasury rate, implied volatility, equity market returns, and the Constant Sharpe Approach, to estimate the Equity Risk Premium (ERP). The ERP and the Capital Asset Pricing Model (CAPM) are used together to calculate the required return on equity for our DCF-based share valuation models.
What Has Changed Since the Last Model Update: The latest FOMC meeting on July 30th/31st resulted in a 25 basis point decrease in the target Fed Funds rate. This is the first rate cut since 2008. The decision was in-line with expectations; However, the market reacted negatively to Chairman Powell’s explanation of the cut representing a “mid-cycle adjustment”. This was initially interpreted to mean that the July cut did not signal the start of a rate cutting cycle. Later in the press conference the Chairman explained that additional future cuts are possible, which stabilized the market, but left spectators someone confused. Ultimately, leaving the door open to future cuts without backing the FOMC into a situation where the market prices in a 100% probability of another cut, is probably a favorable position for the FOMC.
The market’s expectations for future interest rates remain nearly unchanged from our previous check in June. The CME Group’s FedWatch Tool, which estimates the market’s expectation of the Fed Funds rate using pricing of Fed Funds futures contracts, currently implies Fed Funds rates of 2.00% for September, 1.88% for October, and 1.80% for December. This compares to 1.95%, 1.87%, and 1.76% for September, October, and December respectively prior to the latest FOMC meeting. Overall the market continues to price in approximately 30 basis points of further rate cuts for the year. We will see how this estimate changes with the next round of economic data.
Summary of Forecast Approach and Latest Data Changes in the ERP Model: Each quarter the new interest rate, market return, and volatility results must be input into the Equity Risk Premium model. In addition, new estimates must be entered for each metric. This section clarifies the approach used to form the future expectations in the “base-case” version of the ERP model.
Planned ERP Model updates:
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