Estimating Implied Premium in Asset Prices Quiz

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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?

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?

Weighted average

Long-term average

Geometric average

Arithmetic average (correct)

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?

It provides a more accurate estimate due to more historical data. Signup and view all the answers

What is a challenge associated with historical premiums for markets outside the United States?

Lack of historical data availability Signup and view all the answers

How does the text describe the accuracy of estimates derived from historical premiums in emerging markets?

Significantly inaccurate Signup and view all the answers

What is the default approach used by most to arrive at the premium in financial models?

Historical Data Approach Signup and view all the answers

What is one of the limitations of using the Survey Approach to estimate future premiums?

Historical bias in results Signup and view all the answers

What does the Historical Premium Approach calculate to determine the premium to use in models?

Difference between average stock returns and riskless security returns Signup and view all the answers

What issue arises from using surveys to estimate risk premiums, according to the text?

Tendency to produce negative risk premiums Signup and view all the answers

What assumption does the Historical Premium Approach make about investors' risk aversion across time?

Risk aversion changes systematically over time Signup and view all the answers

Why is surveying all investors in a market place considered impractical, according to the text?

Short-term nature of survey results Signup and view all the answers

What are the three inputs needed to use the Capital Asset Pricing Model (CAPM)?

Risk-free rate, expected market risk premium, beta of the asset Signup and view all the answers

Why does the risk-free asset have no variance around the expected return?

Because it is a zero coupon security with same maturity as the cash flow being analyzed Signup and view all the answers

What is the risk-free rate in practice?

A rate on a zero coupon government bond matching the time horizon of the cash flow being analyzed Signup and view all the answers

Why may using different risk-free rates for each cash flow not be worth it in practice?

Because there is substantial uncertainty about expected cash flows Signup and view all the answers

What does the expected market risk premium represent?

The premium for investing in risky assets over the riskless asset Signup and view all the answers

In CAPM, what does beta represent?

'Riskiness' of an asset compared to the market portfolio Signup and view all the answers

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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Description

Test your knowledge on estimating the implied premium in asset prices using historical data. Learn about predicting future premiums based on historical trends and the survey approach in practical scenarios.