(Published in WILMOTT MAGAZINE, Nov/Dec 2002, pp. 84-97)

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The Relationship Between the Equity Risk Premium, Duration and Dividend Yield
 

Ruben D. Cohen (e-mail)

Abstract

Based on the fundamental equations of equity valuation, we derive here the relationship between the equity risk premium, duration and dividend yield. Aside from providing a logical foundation for the difference between the ex-ante and ex-post measures of the risk premium, the work leads to other outcomes, namely, but not specifically, (1) that the current, effective dividend policy is a signalling process, conveying information on expected profits, (2) an alternative valuation relation, stemming from the above-mentioned dividend policy, (3) another proof to the notion that the forward-looking equity risk premium is the expected dividend yield and, finally, (4) a straightforward, analytical explanation for the dividend puzzle and its relation to the observed decline in both, the dividend yield and the forward-looking equity risk premium.