Session 6: Estimating Hurdle Rates - Equity Risk Premiums - Historical & Survey

Session Six: Equity Risk Premium

In this session, the focus is on the equity risk premium as a crucial component of risk and return models in finance. The discussion delves into defining the equity risk premium and exploring how individuals determine this premium based on their risk aversion levels.

Understanding Equity Risk Premium

• The equity risk premium represents the additional return investors demand for investing in an average-risk investment compared to a risk-free rate.

• Factors influencing the equity risk premium include being greater than zero, varying based on individual risk aversion levels influenced by factors like age and gender.

• Risk aversion plays a significant role in determining one's equity risk premium, with more risk-averse individuals demanding higher premiums.

Experimenting with Risk Aversion

• An experiment is proposed where individuals are asked how much more than a guaranteed three percent return they would require to invest in stocks, highlighting varying degrees of risk aversion.

• Different ranges of responses indicate different levels of risk aversion among participants, impacting their willingness to invest in risky assets.

Estimating Market Equity Risk Premium

• The collective estimation of individual equity risk premiums can be used to derive an overall market equity risk premium by weighting each individual's premium based on their investment size.

Investor Risk Premiums Analysis

In this section, the speaker discusses different approaches to estimating equity risk premiums for investors. The three main methods covered are survey-based premiums, historical premiums, and forward-looking premiums.

Survey Approach

• Surveys provide insights into investor expectations.

• Surveying subsets of investors reveals discrepancies between expectations and hopes.

• Various surveys by institutions like Merrill Lynch and researchers like Pablo Fernandez report premium estimates ranging from 3.5% to 6%.

Historical Premium Estimation

• Historical data analysis offers another method to estimate risk premiums.

• Calculating the difference in returns between stocks and T-bonds over a specific period provides a historical premium.

• Different time frames (e.g., 10 years, 50 years) yield varying premium estimates due to market conditions.

Considerations for Historical Premiums

• Recommendations for using historical risk premiums effectively.

• Going back as far as possible reduces statistical errors in premium estimates.

• Consistency in defining the risk-free rate is crucial for accurate calculations.

Global Market Risk Premium Challenges

This segment delves into the challenges of applying historical risk premiums outside the US due to limited market history in regions like India, China, and Brazil.

Global Market Risk Premium Issues

• Limited historical data poses challenges for non-US markets.

• Markets such as India, China, and Brazil lack extensive historical data for reliable risk premium estimations.

Study on Global Equity Risk Premium

• Credit Suisse's annual study examines equity risk premiums across various markets globally.

Understanding Risk Premiums in Global Markets

In this section, the speaker discusses the challenges of estimating risk premiums in markets without historical data and proposes a method to calculate equity risk premiums for countries outside the US.

Estimating Risk Premiums in Non-US Markets

• Historical data has limitations with a standard error of about two percent even across multiple markets and a hundred years of data.

• Utilizing sovereign default spreads can help estimate risk premiums in markets lacking historical data.

• To calculate equity risk premiums for countries like India, China, and Brazil:

• Add the default spread of each country to the US equity risk premium.

Refining Country Risk Premium Estimations

• Extend the approach to any country with sovereign CDS spreads or ratings by adding default spreads to the US risk premium.

• This method is commonly used by practitioners for estimating country risk premiums.

• Adjusting for relative risks between equities and bonds involves considering standard deviations of equity indices and government bonds.

• Equities are typically riskier than bonds; thus, adjustments are made based on these differences.

• Scaling up default spreads based on relative risks helps define equities' additional risks in different countries like India, Brazil, and China.

• Standard deviations of equity indices and government bonds play a crucial role in this adjustment process.