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Essay
Estimating Risk Premiums In Practice
Prof.&Emiliano&Pagnotta epagnott@ic.ac.uk Autumn&2016 Corporate(Finance Estimating(Risk(Premiums(in(Practice 1. Survey&investors&on&their&desired&risk&premiums&and&use&the& average&premium&from&these&surveys. 2. Assume&that&the&actual&premium&delivered&over&long&time& periods&is&equal&to&the&expected&premium&-i.e.,&use&historical& data 3. Estimate&the&implied&premium&in&todays&asset&prices. What(is(your(risk(premium? Assume& that&stocks&are&the&only&risky&assets& and&that&you&are&offered&two& investment& options: a&riskless&investment&(say&a&Government&Security),&on&which&you&can&make&3% a&mutual&fund&of&all&&stocks,&on&which&the&returns&are&uncertain How&much&of&an&expected& return&would&you&demand&to&shift&your&money&from&the& riskless& asset&to&the&mutual&fund? a. Less&than&3% b. Between& 3%&-5% c. Between& &5%&-7% d. Between& &7%&-9% e. Between& 9%-11% f. More&than&&11% The(Survey(Approach Surveying&all&investors& in&a&market&place&is&impractical. However,&you&can&survey&a&few&individuals& and&use&these& results.&In&practice,&this& translates& into&surveys&of&the&following: The&limitations& of&this&approach&are: There&are&no&constraints&on&reasonability&(the&survey&could&produce&negative&risk& premiums&or&risk&premiums&of&50%) The&survey&results&are&more&reflective&of&the&past than&the&future. They&tend&to&be&short&term;&even&the&longest&surveys&do&not&go&beyond&one&year. The(Historical(Premium(Approach This&is&the&default&approach&used&by&most&to&arrive&at&the&premium&to&use&in&the& model In&most&cases,&this&approach&does&the&following Defines&a&time&period&for&the&estimation&(1928-Present,&last&50&years...) Calculates&average&returns&on&a&stock&index&during&the&period Calculates&average&returns&on&a&riskless&security&over&the&period Calculates&the&difference& between& the&two&averages&and&uses&it&as&a&premium&looking& forward. The&limitations& of&this&approach&are: it&assumes&that&the&risk&aversion&of&investors&has&not&changed&in&a&systematic&way&across& time.&(The&risk&aversion&may&change&from&year&to&year,&but&it&reverts&back&to&historical& averages) it&assumes&that&the&riskiness&of&the&riskyportfolio&(stock&index)&has&not&changed&in&a& systematic&way&across&time. Historical&data&for&markets&outside&the&United&States&and&the&U.K.&is&more&limited The(Historical(Risk(Premium:((Evidence(from(the(United(States If&you&are&going&to&use&a&historical& risk&premium,&make&it Long&term&(because& of&the&standard&error) Consistent& with&your&risk&free&rate A&compounded&average.&For&long-term&analysis&geometric& avg.&is&better. No&matter&which&estimate& you&use,&recognize&that&it&is&backward&looking,&is&noisy and&may&reflect&selection& bias. Historical premium for the US Std Error in estimate = Annualized Std deviation in Stock prices Number of years
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