A First Cut Estimate of Equity Risk Premium in India

Jayanth R Varma Samir K Barua June 2006

The equity risk premium is the expected excess of the aggregate return in the stock market (Rm) over the Risk-free rate (Rf). According to the CAPM, the expected return on any stock over the Rf is equal to the equity risk premium (Rm-Rf) times the riskiness of the stock as measured by its beta. This paper attempts to estimate the equity risk premium in India. The BSE has published an electronic database of stock prices in India for the period 1981-2001. BSE Index was first compiled in 1986 and was calculated back to 1979. The Index stocks were chosen out of stocks with the largest market capitalisation at that time. This would cause an upward bias in the Index returns from 1979 to 1986.Till August 1996 there was no revision in the Index making it unrepresentative of the Indian Stock Market. Till mid-1990 it was a price index and not a total return index. Between 1997 – 2005 the annual returns on the total return index has exceeded that of the price index by over 2% annually. The Index that was constructed by the authors in this paper is an equally weighted index of the most liquid stocks that have traded on atleast 95% of the trading days in the previous years. The dividend are captured to make it a total return index by selling the stocks and buying it back next day when it goes X dividends. They use the equally weighted index from 1981 – 1996 and chain it into the sensex total return index at the beginning of 1997. The 1981 -1996 index exceeds the sensex index by about 0.15% implying that the omission of the dividend yield has roughly compensated for the self selection bias of the index. They used Varma estimates that the repression of interest rates amounted to about 3%. While the deposit rate exceeded the call rate by 1.5%, post deregulation, it was below the call rate by 1.5% pre deregulation.

The reason for this divergence between the sub period behaviours of two means is the increase in the annualised standard deviation of the stock market returns from less than 20% in the pre-reform period to about 25% in the post-reform period. Pragya Mishra 12153. It was found that the equity risk premium is about 8.75% on a geometric mean basis and about 12. The higher standard deviation depresses the geometric mean in the post-reform period.5% on an arithmetic mean basis. Sec ‘C’ . There is no significant difference between the pre-reform and post-reform period: The premium has declined marginally on a geometric mean basis and has risen slightly on an arithmetic mean basis.They then computed the average annual market return and subtracted the average risk free rate from it to estimate the risk premium.