Podcast
Questions and Answers
What assumption does the statement 'risk aversion may change from year to year, but it reverts back to historical averages' make about the risky portfolio?
What assumption does the statement 'risk aversion may change from year to year, but it reverts back to historical averages' make about the risky portfolio?
- The risky portfolio has decreased in riskiness over time.
- The risky portfolio's riskiness can be accurately predicted in the future.
- The risky portfolio's riskiness has remained constant over time. (correct)
- The risky portfolio has increased in riskiness over time.
Which type of average should be used for one-year estimates of the cost of equity according to the text?
Which type of average should be used for one-year estimates of the cost of equity according to the text?
- Weighted average
- Long-term average
- Geometric average
- Arithmetic average (correct)
What does the 'standard error in estimate' formula in the text depend on?
What does the 'standard error in estimate' formula in the text depend on?
- Number of years of historical data (correct)
- Historical volatility of stocks
- Geometric mean of premiums
- Historical volatility of T.Bills
Why is using longer-term data preferred when estimating costs of equity according to the text?
Why is using longer-term data preferred when estimating costs of equity according to the text?
What is a challenge associated with historical premiums for markets outside the United States?
What is a challenge associated with historical premiums for markets outside the United States?
How does the text describe the accuracy of estimates derived from historical premiums in emerging markets?
How does the text describe the accuracy of estimates derived from historical premiums in emerging markets?
What is the default approach used by most to arrive at the premium in financial models?
What is the default approach used by most to arrive at the premium in financial models?
What is one of the limitations of using the Survey Approach to estimate future premiums?
What is one of the limitations of using the Survey Approach to estimate future premiums?
What does the Historical Premium Approach calculate to determine the premium to use in models?
What does the Historical Premium Approach calculate to determine the premium to use in models?
What issue arises from using surveys to estimate risk premiums, according to the text?
What issue arises from using surveys to estimate risk premiums, according to the text?
What assumption does the Historical Premium Approach make about investors' risk aversion across time?
What assumption does the Historical Premium Approach make about investors' risk aversion across time?
Why is surveying all investors in a market place considered impractical, according to the text?
Why is surveying all investors in a market place considered impractical, according to the text?
What are the three inputs needed to use the Capital Asset Pricing Model (CAPM)?
What are the three inputs needed to use the Capital Asset Pricing Model (CAPM)?
Why does the risk-free asset have no variance around the expected return?
Why does the risk-free asset have no variance around the expected return?
What is the risk-free rate in practice?
What is the risk-free rate in practice?
Why may using different risk-free rates for each cash flow not be worth it in practice?
Why may using different risk-free rates for each cash flow not be worth it in practice?
What does the expected market risk premium represent?
What does the expected market risk premium represent?
In CAPM, what does beta represent?
In CAPM, what does beta represent?
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Study Notes
Estimating the Risk Premium
- There are two approaches to estimate the risk premium: survey approach and historical premium approach
- The survey approach involves surveying investors to estimate the premium, but it has limitations such as lack of constraints on reasonability and reflection of past rather than future expectations
- The historical premium approach is the default approach, which involves calculating the average returns on a stock index and a riskless security over a defined period and using the difference as the premium
Historical Premium Approach
- This approach assumes that the risk aversion of investors has not changed systematically over time and that the riskiness of the "risky" portfolio has not changed significantly over time
- The approach estimates the premium by calculating the average returns on a stock index and a riskless security over a defined period
CAPM Inputs
- To use the CAPM, three inputs are required:
- The current risk-free rate
- The expected market risk premium
- The beta of the asset being analyzed
Risk-Free Rate in Practice
- The risk-free rate is the rate on a zero-coupon government bond matching the time horizon of the cash flow being analyzed
- In practice, using different risk-free rates for each cash flow may not be necessary due to the small present value effect of using time-varying risk-free rates
Historical Risk Premium: Evidence from the US
- The historical risk premium can be estimated using historical data from the US market
- The estimated premiums vary depending on the time period used, with longer periods providing more accurate estimates
- The arithmetic average and geometric average premiums are used for one-year and long-term estimates of costs of equity, respectively
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