The Estimation Of Equity Risk Premium For Canada

In this paper I assess the equity risk premium for Canada. In order to accomplish the task, I use three different procedures. The first procedure extends the seminal Mehra and Prescott (1985) article and examines whether the equity risk premium puzzle exists for Canada during the last fifty years. This approach incorporates the conventional parameters of risk aversion and the time discount factor generally accepted by the existing literature. Moreover, the estimates of those parameters are derived which correspond to the observed premium provided by Canadian equities over risk free debt. The second procedure is based on Fama and French (2002). Different estimates of the risk premium are calculated using two growth models based on the growth rate of aggregate dividends and the growth rate of operating earnings. The third, and final, is the decomposition model based on the methodology employed by Dimson, Marsh and Staunton (2006). The main results argue for the existence of an equity premium puzzle for Canada, as the estimated parameter of risk aversion of the average investor is unrealistically high. Additionally, the estimates of the expected risk premium in real values using the growth and decomposition models argue for a smaller magnitude the historical risk premium.