Equity Risk Premium. An Estimate Inspired on Behavioural Finance

Although Capital Asset Pricing Model is very convenient for estimating the Cost of Capital for long-term investments, it requires the determination and use of a value for the equity risk premium (ERP). Using Prospect Theory introduced by Kahneman and Tversky and assuming a Brownian motion for any volatile asset, it seems possible to estimate such a premium from two market parameters – volatility and risk-free rate – and from the estimates of two human characteristics – the multiple of the valuation of the pain produced by losses in comparison to the satisfaction extracted from the alternative gains, plus the non-linearity of the risk-aversion/risk-loving curve. Under common values for these parameters, the ERP should be 7% p.a. Therefore, it seems that Mehra and Prescott estimated an insufficient premium, because they considered only that non-linearity, and not the gains-losses asymmetry