The risk premium refers to the extra return awarded

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: • What goes into the NPV formula is the expected return, not any of the other 2. • The risk premium refers to the extra-return awarded for holding undiversifiable risk. • Default risk and diversifiable risk are very important for the NPV formula, but only when you are computing expected cash flows (numerator), not expected returns (denominator). • When computing actual (ex-post, observable) returns, whether there is default or not, and what realization of the random process for cash flows you got are, of course, tremendously important. 2 Inputs in the CAPM formula E (ri) = rF + β i[E (rm) − rF ] 2.1 Risk-free rate • In empirical applications use the interest rate from Treasury bills with comparable horizon as the returns under study. Why T-bills? Presumably, no default risk, no liquidity risk, no risk close as it is going to get to time premium. • The CAPM is truly a one-period model, so there isn’t really a concept of different risk-free rates based on different horizons. 2.2 Beta • Huge problem: beta is forward looking and we only have historical data. As we said bef...
View Full Document

{[ snackBarMessage ]}

Ask a homework question - tutors are online