Implied Rates of Return, the Discount Rate Effect, and Market Risk Premia

In the literature, implied rates of return are suggested as estimators for future expected oneperiodreturns because of their property not being prone to the discount rate effect. The discount rateeffect describes the problem that changes in expected future one-period returns lead to oppositechanges in stock prices and thus realized rates of return with the latter being often utilized as the basisfor estimations of future expected one-period returns. Moreover, implied rates of return are typicallysmaller than average realized rates of return and thus corresponding estimates for future expectedone-period returns are viewed as a potential resolution of the equity premium puzzle. This puzzlestates that expected rates of return must be considerably lower than those estimates computed on thebasis of historical return realizations in order to be in line with reasonable risk preference assumption.We show analytically under quite general conditions that implied rates of return based on analysts’earnings forecasts are only a downward biased estimator for future... [