riskprem - Estimating Equity Risk Premiums Aswath Damodaran...

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Estimating Equity Risk Premiums Aswath Damodaran Stern School of Business 44 West Fourth Street New York, NY 10012 Adamodar@stern.nyu.edu
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Estimating Equity Risk Premiums Equity risk premiums are a central component of every risk and return model in finance. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. The standard approach to estimating equity risk premiums remains the use of historical returns, with the difference in annual returns on stocks and bonds over a long time period comprising the expected risk premium, looking forward. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to limited and noisy. We suggest ways in which equity risk premiums can be estimated for these markets, using a base equity premium and a country risk premium. Finally, we suggest an alternative approach to estimating equity risk premiums that requires no historical data and provides updated estimates for most markets.
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Equity Risk Premiums The notion that risk matters, and that riskier investments should have a higher expected return than safer investments, to be considered good investments, is intuitive. Thus, the expected return on any investment can be written as the sum of the riskfree rate and an extra return to compensate for the risk. The disagreement, in both theoretical and practical terms, remains on how to measure this risk, and how to convert the risk measure into an expected return that compensates for risk. This paper looks at the estimation of an appropriate risk premium to use in risk and return models, in general, and in the capital asset pricing model, in particular. Risk and Return Models While there are several competing risk and return models in finance, they all share some common views about risk. First, they all define risk in terms of variance in actual returns around an expected return; thus, an investment is riskless when actual returns are always equal to the expected return. Second, they all argue that risk has to be measured from the perspective of the marginal investor in an asset, and that this marginal investor is well diversified. Therefore, the argument goes, it is only the risk that an investment adds on to a diversified portfolio that should be measured and compensated. In fact, it is this view of risk that leads risk models to break the risk in any investment into two components. There is a firm-specific component that measures risk that relates only to that investment or to a few investments like it, and a market
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component that contains risk that affects a large subset or all investments. It is the latter risk that is not diversifiable and should be rewarded. While all risk and return models agree on this fairly crucial distinction, they part
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This note was uploaded on 01/30/2012 for the course FIN 6000 taught by Professor Banko during the Fall '11 term at University of Florida.

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riskprem - Estimating Equity Risk Premiums Aswath Damodaran...

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