April 29, 2020

Why the equity risk premium has increased

The stock market rebounded following fiscal and monetary policy announcements: it is now about 20% below its pre-crisis level. In the previous post, we saw that the expected fall in corporate earnings can account for only a fraction of the market decline. To explain the full market decline (even after the rebound), we must recognize that the equity risk premium has gone up.

There exist three reasons why the equity risk premium has increased, which are summarized by the following formula:

Equity risk premium = (Risk aversion) x (Macro risk) x (Sensitivity of earnings to macro risk)

The equity risk premium is the expected market return that makes investors willing to buy stocks. When investors are more averse to risk, it takes a higher risk premium to make them willing to buy stocks: this is the first factor in the formula.

When macroeconomic risk increases, stocks become more risky, so the equity risk premium must increase to compensate investors for bearing this risk: this is the second factor in the formula. Finally, holding macroeconomic risk constant, if corporate earnings are more sensitive to economic conditions, stocks are more risky and the equity risk premium must be higher: this is the third factor in the formula.

It is a priori plausible that all three factors contributed to the increase in the risk premium. Indeed, during recessions, investors become more risk averse, macroeconomic risk increases, and corporate earnings become more sensitive to economic conditions. However, in a research paper just out, Augustin Landier and David Thesmar argue that the increase in the equity risk premium is fully explained by the third factor.

To illustrate the intuition, consider a firm which used to generate risky revenues in the range from 140 to 160 before the crisis. The firm has interest expenses of 50. Therefore, in the pre-crisis world, earnings (which are equal to revenues minus interest expenses) are in the range 90 to 100: there is a 10% uncertainty in earnings (earnings are equal to 100 plus or minus 10).

Now, suppose the crisis reduces revenues by half: revenues are now in the range 70 to 80. Interest expenses are still 50, so earnings are now in the range 20 to 30: there is a 20% uncertainty in earnings (earnings are equal to 25 plus or minus 5). Therefore, earnings are now twice as risky as they were before the crisis even though revenues before interests are not more risky! This happens because interest expenses are fixed: this effect is called debt leverage. When Landier and Thesmar make this calculation using the actual numbers, they find that the increase in debt leverage fully explains the increase in the equity risk premium.

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