Modelling equity market term structures

Abstract

We outline a methodology for estimating term structures of expected dividend growth and risk premiums, which we apply to equity markets in the US, euro area, Japan, and the UK. These term structures are key inputs when estimating expected returns on the market and decomposing equity price movements. Our estimation approach relies on the use of dividend futures prices, which provide a way to breakdown the market into value associated with fixed horizons. We combine these futures prices with stock index prices, options data, and surveys within a present-value framework, allowing us to estimate term structures that extend to long maturities. Our model produces dividend growth and risk premium term structures that explain high proportions of the variation in stock index prices, and closely match dividend futures prices. There is considerable cyclical variation in the expected dividend growth estimates, particularly at shorter horizons. Similarly, short-term risk premiums vary considerably more than long-horizon estimates, and increase sharply during market downturns. The present-value approach allows us to decompose stock market values by horizon, and indicates that the majority of the value occurs beyond ten years for all markets. This is also reflected in estimates of equity market duration, which range from 20 to 25 years for the US and Japan, and 15 to 20 years for the euro area and UK.