Estimating the Market Risk Premium

Abstract

This paper provides a methodology for estimating the market risk premium based on the underlying process governing the level of market volatility. My model provides a test for a structural shift in the historical risk premium and an unbiased estimate of its value. I provide evidence of a structural shift in the volatility process following the 1930s that implies an upward bias in ex post realized returns during the subsequent period. Controlling for this bias, my estimate of the market risk premium for the period after 1940 is 5.9% over the yield on Treasury bills. My model also provides a lower-bound on forward-looking estimates of the current risk premium of 4.2% over the yield on Treasury bills.

Note: This paper is a revised version of an earlier paper titled "State-dependent Volatility and the Market Risk Premium"

JEL Classification: G10, G12, G31