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Why is S&P 500 a good proxy for the implied equity risk premium (ERP) estimation?

Why is S&P 500 a good proxy for the implied equity risk premium (ERP) estimation?

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Expert Solution

The equity risk premium ca be calculated using the formula:

E(RM) - Risk free rate.

For example:

Between a certain period of time , the S&P 500 exhibited a 15% compounding annual rate of return, while the 30-day Treasury bill compounded at 5%. This indicates a market risk premium of 10%, based on these parameters.

A market proxy is a representation of the overall market. The S&P is a good proxy for the return on the market  because :

  • It is a US market index.
  • It is based on the market capitalization of 500 companies traded on the NYSE, and the NASDAQ stock exchange.It provides 80% coverage of the available market capitalization. It also includes a diverse makeup of industries to better represent the overall market.
  • It is a free float market capitalization weighted index, since it is free float it only includes shares which are actively trading in the market.
  • This index is famous among investors due to its stability, transparency of construction, its history and its ability to represent the overall market.

jeff jeffy answered 1 year ago
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