Inflation, Interest Rates and Equity Risk Premia

The conventional belief that the market risk premium is positive, and that the market requires a greater return on stocks than it does on bonds, neglects the impact of inflation on the risk inherent in debt and equity securities. With uncertain inflation, the bond investor faces substantial risk of capital loss, whereas the firm’s ability to raise prices offers some protection to the shareholders. Call provisions can also detract from the attractiveness of a bond under uncertain inflation.

These arguments, together with certain anecdotal evidence, suggest that the market risk premium may narrow during periods of uncertain inflation. Counting against this point of view, however, are the studies by Ibbotson and Sinquefield estimating equity risk premia from ex post holding period returns on stocks and bonds, which indicate that the market risk premium for stocks vis-à-vis bonds has averaged five to eight per cent over long periods of time.

On the other hand, ex post holding period returns are composed of an ex ante expected return plus a component of unanticipated return, which will be negative or positive depending on whether investors under or overestimate expected returns. If the mean unanticipated component of return on stocks does not equal the mean unanticipated component of return on bonds, then holding period return spreads between stocks and bonds will not accurately reflect ex ante risk premia.

Empirical analysis indicates that holding period return spreads from 1926 to the present overestimated the true market risk premium. Further analysis supports the notion that in recent years, the risk premium on stocks vis-à-vis bonds has declined. In 1980, in fact, it was negative.