CAPM

MARKET RISK PREMIUM

What is a reasonable
estimate of its value ?

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
20
E
x 18
p 16
e
14
c
t 12 Market
e Risk
10
d Premium
8
RF
R
e 6
t 4
u
2
r
n 0
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 13%
minus

Current Nominal Risk-free Interest Rate 7%

Prospective estimate of RPm 6%

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

Arithmetic Average Geometric Average

R = (+25% - 20%) / 2 G = [(1.25)(0.8)]1/2 - 1

= 2.5% = 0.0%

03/21/08 Robert C. Radcliffe 9

 Arithmetic Average Returns
1926-1996

Nominal Real

CPI 3.22% 0.00%

Treasury Bills 3.80% 0.58%

Treasury Bonds 5.47% 2.24%

Corp. Bonds 5.94% 2.72%

S&P 500 12.67% 9.45%

Smallest 20% 18.65% 15.43%

03/21/08 Robert C. Radcliffe 10

 Geometric Average Returns
1926-1996

Nominal Real

CPI 3.12% 0.00%

Treasury Bills 3.75% 0.48%

Treasury Bonds 5.10% 1.70%

Corp. Bonds 5.61% 2.20%

S&P 500 10.71% 7.35%

Smallest 20% 12.46% 9.10%

03/21/08 Robert C. Radcliffe 11

 Implied Risk Premiums
using S&P500 as Market Proxy
Proxy for Arithmetic Arithmetic Geometric Geometric
RF Nominal Real Nominal Real
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 S&P minus Tbills

0.12 S&P minus Tbonds

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

03/21/08 Robert C. Radcliffe 14

 Estimates of RPm
Using 20-years Geometric Returns

0.16 S&P minus Tbills

0.14 S&P minus Tbonds

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

03/21/08 Robert C. Radcliffe 15

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 3.6% 5.1% 6.8% 8.5% 10.1%
Tbills
SP500
minus 2.0% 3.5% 5.2% 6.4% 8.4%
Tbonds

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