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03/21/08

Robert C. Radcliffe

1

What it is “Conceptually”

The annual rate of return which investors require in order to be willing to own shares of an “Average Risk” stock The expected return on the “MARKET PORTFOLIO” minus the “RISK-FREE RATE”

03/21/08

Robert C. Radcliffe

2

**Graphic Depiction of RPm
**

E x p e c t e d R e t u r n 20 18 16 14 12 10 8 RF 6 4 2 0 Market Risk Premium

0

0.5

1

1.5

2

Beta:Non-Diversifiable Risk

03/21/08

Robert C. Radcliffe

3

What is it “NUMERICALLY”

Issues in estimating RPm:

Approach: Prospective or Historical Arithmetic or Geometric average past measures Does it change (what periods should be used) Calculation of statistical confidence intervals Should long-term investors demand a smaller risk premium than short-term investors

03/21/08

Robert C. Radcliffe

4

**What Approach s/b Used
**

Prospective

Estimate expected return on stock market and subtract “the” current risk-free rate

Historical

Calculate the average risk premium which investors have actually earned in the past

03/21/08

Robert C. Radcliffe

5

**Prospective Estimates of RPm
**

Expected Future Annual Market Return

minus

13% 7% 6%

Current Nominal Risk-free Interest Rate Prospective estimate of RPm

**Expected Future Market Return might consist of:
**

Current Dividend Yield on stock index such as S&P 500 3%

plus long-run dividend growth (must be constant growth) 10% Expected Market Return 13%

03/21/08

Robert C. Radcliffe

6

**Prospective Estimates of RPm: Problems in Application Requires estimates of future dividend growth
**

-- either a constant growth assumption, -- or specified yearly dividend growth

These are difficult to estimate Analyst forecasts of future dividend growth have not been very accurate Analysts often forecast future expected returns from past returns So why not simply look at past return data

03/21/08 Robert C. Radcliffe 7

**Using Historical Earned Risk Premiums as Sample Estimates of RPm
**

The logic is: “On average investors will receive what they expect. So lets look at what they have received to estimate the risk premium they have desired in the past.” Earned Risk Premium in year t = Actual Stock Market Return in t minus Estimate of Risk-free Rate in year t

03/21/08 Robert C. Radcliffe 8

**How Should the Average “Earned Risk Premium” be Measured
**

Date: 0 Return between dates Wealth $1 1 +25% $1.25 -20% $1 2

**Arithmetic Average R = (+25% - 20%) / 2 = 2.5%
**

03/21/08

Geometric Average G = [(1.25)(0.8)]1/2 - 1 = 0.0%

9

Robert C. Radcliffe

**Arithmetic Average Returns
**

1926-1996

Nominal CPI Treasury Bills Treasury Bonds Corp. Bonds S&P 500 Smallest 20% 3.22% 3.80% 5.47% 5.94% 12.67% 18.65%

Real 0.00% 0.58% 2.24% 2.72% 9.45% 15.43%

03/21/08

Robert C. Radcliffe

10

**Geometric Average Returns
**

1926-1996

Nominal CPI Treasury Bills Treasury Bonds Corp. Bonds S&P 500 Smallest 20% 3.12% 3.75% 5.10% 5.61% 10.71% 12.46%

Real 0.00% 0.48% 1.70% 2.20% 7.35% 9.10%

03/21/08

Robert C. Radcliffe

11

**Implied Risk Premiums using S&P500 as Market Proxy
**

Proxy for Arithmetic Arithmetic Geometric Geometric Nominal Real Nominal Real RF Treasury 8.87% 8.87% 6.96% 6.87% Bills Treasury 7.20% 7.20% 5.61% 5.65% Bonds

**The choice of R or G does matter
**

03/21/08 Robert C. Radcliffe 12

Which is Better: R or G

G represents a compound return. For capital budgeting purposes, we are also using compound returns. For consistentcy, use geometric average values when estimating the Market Risk Premium RPm This issue is much debated, no common concensus.

03/21/08 Robert C. Radcliffe 13

Estimates of RPm

Using 30-years Geometric Returns

0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 19 19 19 19 19 19 19 19 19 19 19 19 19 19 54 57 60 63 66 69 72 75 78 81 84 87 90 93 S&P minus Tbills S&P minus Tbonds

03/21/08

Robert C. Radcliffe

14

Estimates of RPm

Using 20-years Geometric Returns

0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 -0.02 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 44 47 50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95

Robert C. Radcliffe 15

S&P minus Tbills S&P minus Tbonds

03/21/08

**Do Market Risk Premiums Change
**

They probably do change as investor perceptions of market risk change However, any past estimates are so variable and uncertain that we simply can not identify changes. Conclusion, use all returns available

03/21/08

Robert C. Radcliffe

16

**Statistical Confidence Limits on RPm
**

Based on Geometric Average 1926-1996

Percentile

10th

25th

50th

75th

90th

SP500 minus Tbills SP500 minus Tbonds

3.6%

5.1%

6.8%

8.5%

10.1%

2.0%

3.5%

5.2%

6.4%

8.4%

03/21/08

Robert C. Radcliffe

17

Exercises

Review the worksheet “RiskPremium” on the file LectureMaterials.xls

03/21/08

Robert C. Radcliffe

18

Review Questions

1. Why are arithmetic means of security returns greater than geometric means? Develop an example of this using numbers other than presented in these notes. 2. Which type of mean return is more meaningful to investors? (Hint: Does the investment horizon matter.) 3. What is the logic associated with using past “earned” risk premiums” as estimates of the current market risk premium?

03/21/08 Robert C. Radcliffe 19

Review Questions

4. Go to the “Yrly_INDXRTNS” worksheet in the FinlMgtData.xls spreadsheet. Calculate yearly earned risk premiums for all years possible as follows: Risk Premium Earned = a. SP500 return minus Tbill return b. SP500 return minus Tbond return 5. Find the arithmetic average and standard deviation for both approaches. 6. Find the geometric average earned risk premium.

03/21/08

Robert C. Radcliffe

20

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