Dividend-Price Ratio and Interest Rate Movements:
Explaining the Equity Risk Premium

Abstract

This article shows that, over time and across many countries, only a subset of long-term interest rate fall years is responsible for the high equity premium realized over the following periods. These are the years when the dividend-price ratio increases. This observed price behavior could be due to a tendency for prospective equity risk premium to increase when the interest rate declines. The reverse is true: Only a subset of interest rate rise years is responsible for the low or negative subsequent equity premium. These are the years when the dividend-price ratio decreases and the expected equity risk premium falls. This equity premium predictability is present at the international level over the 1971–2014 period, and contrary to previous studies, it does not appear to be only a recessionary phenomenon.

TOPICS: Fundamental equity analysis, analysis of individual factors/risk premia, global, performance measurement