The Implied Equity Premium

We propose and test a simple model of the equity premium implied by stock index options, assuming frictionless and complete markets for the index and index options. The model’s forecasts are more accurate than forecasting benchmarks, especially when arbitrage costs are low. They closely match real market behavior, with an average equity premium of 7.9% and an implied Sharpe ratio of 0.36. Our model offers fresh economic insights into why the premium varies, including its sustained increase after the 2008 crisis, and provides a unified explanation of risk premiums for variance and higher-order moments of market returns.