Equity Risk Premium Model
Latest Update: October 6, 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 September 18, 2019 resulted in a 25 basis point decrease in the target Fed Funds rate. The decision was in-line with market expectations. This meeting showed some differences in opinion between the FOMC members, with James Bullard voting to cut rates by 50 basis points, and Esther George and Eric Rosengren voting for no rate cut.
The market’s expectations for future interest rates continued to decrease. The CME Group’s FedWatch Tool, which estimates the market’s expectation of the Federal Funds rate using pricing of Federal Funds futures contracts, currently implies Federal Funds rates of 1.70% for October (down from 1.89% in July), 1.70% for December (down from 1.89%).
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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