18 Questions
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's riskiness has remained constant over time.
Which type of average should be used for one-year estimates of the cost of equity according to the text?
Arithmetic average
What does the 'standard error in estimate' formula in the text depend on?
Number of years of historical data
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.
What is a challenge associated with historical premiums for markets outside the United States?
Lack of historical data availability
How does the text describe the accuracy of estimates derived from historical premiums in emerging markets?
Significantly inaccurate
What is the default approach used by most to arrive at the premium in financial models?
Historical Data Approach
What is one of the limitations of using the Survey Approach to estimate future premiums?
Historical bias in results
What does the Historical Premium Approach calculate to determine the premium to use in models?
Difference between average stock returns and riskless security returns
What issue arises from using surveys to estimate risk premiums, according to the text?
Tendency to produce negative risk premiums
What assumption does the Historical Premium Approach make about investors' risk aversion across time?
Risk aversion changes systematically over time
Why is surveying all investors in a market place considered impractical, according to the text?
Short-term nature of survey results
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
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
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
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
What does the expected market risk premium represent?
The premium for investing in risky assets over the riskless asset
In CAPM, what does beta represent?
'Riskiness' of an asset compared to the market portfolio
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
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.
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