The risk premium refers to the extra return awarded

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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 premium...as 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...
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