what is your forecast for the equity risk premium 2

Assignment: Grinold Kroner Model (100 words)

First, some review:

E(Re)=[D0(1+g)/(V0)] + g =[D1/(P0)] +g

In the above equation, we make a simple modification to the infinite period dividend discount model,[Po=D1/k-g], to solve for the expected return on the market (thus we can forecast the price next year). In words, the price now equals the dividend next year divided by the required return less growth. The above equations just solves for k. k is the same as E(Re) in the above equation. Sometimes we call it expected return, or sometimes we call it required return. Same thing. If we have the price of a stock, or an index value, and an estimate for next year dividend and growth we can estimate the expected(required return) on the market. One way to estimate growth is using [retention rate x ROE].

Next, we can look at the infinite period dividend discount model.. Po=D1/k-g…and divided both sides by earnings to provide some theoretical basis for the PE ratio. The PE ratio is a measure of relative value and shows the value, or multiple, the investors are willing to pay to own a share of the earnings:

Pi/E1 = (D1/E1)/(k-g)

Shiller discusses the PE ratio measured with 10 year inflation adjusted numbers. Our next step is to come up with another way to forecast for the market, using some of these ideas. The associated reading with this assignment discusses the Grinold Kroner Model:

Answer the question: What is your forecast for the equity risk Premium?

EX:For forecasting equity risk premium, we have to look at technical indicators alongside macroeconomic variables. Technical indicators show us business cycle peaks and how they relate to the decline in equity risk premium, while macroeconomic trends show us cyclical troughs and the rise in equity risk premium near these. Technical indicators are statistically important values while some examples of macroeconomic variables are dividend yields, price earnings ratios, inflation, and volatility of stock prices.

For forecasting the equity risk premium, one can apply the Grinold-Kroner model. The Grinold-Kroner model is a model that forecasts the equity risk premium by subtracting the change in outstanding shares from the dividend yield, and adding inflation, the market or firm’s growth rate, plus the change in PE multiple.


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