In fact it is this view of risk that leads us to break the risk in any

In fact it is this view of risk that leads us to

This preview shows page 6 - 8 out of 133 pages.

diversified portfolio that should be measured and compensated. In fact, it is this view of risk that leads us 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 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. All risk and return models agree on this crucial distinction, but they part ways when it comes to how to measure this market risk. In the capital asset pricing model (CAPM), the
Image of page 6
Electronic copy available at: 7 market risk is measured with a beta, which when multiplied by the equity risk premium yields the total risk premium for a risky asset. In the competing models, such as the arbitrage pricing and multi-factor models, betas are estimated against individual market risk factors, and each factor has its own price (risk premium). Table 1 summarizes four models, and the role that equity risk premiums play in each one: Table 1: Equity Risk Premiums in Risk and Return Models Model Equity Risk Premium Expected Return = Riskfree Rate + Beta Asset (Equity Risk Premium) Risk Premium for investing in the market portfolio, which includes all risky assets, relative to the riskless rate. Arbitrage pricing model (APM) Risk Premiums for individual (unspecified) market risk factors. Multi-Factor Model Risk Premiums for individual (specified) market risk factors Proxy Models Expected Return = a + b (Proxy 1) + c (Proxy 2) (where the proxies are firm characteristics such as market capitalization, price to book ratios or return momentum) No explicit risk premium computation, but coefficients on proxies reflect risk preferences. All of the models other than proxy models require three inputs. The first is the riskfree rate, simple to estimate in currencies where a default free entity exists, but more complicated in markets where there are no default free entities. The second is the beta (in the CAPM) or betas (in the APM or multi-factor models) of the investment being analyzed, and the third is theappropriate risk premium for theportfolio of all riskyassets (in the CAPM) and the factor risk premiums for the market risk factors in the APM and multi-factor models. While I examine the issues of riskfree rate and beta estimation in companion pieces, I will concentrate on the measurement of the risk premium in this paper. Note that the equity risk premium in all of these models is a market-wide number, in the sense that it is not company-specific or asset-specific but affects expected returns on all risky investments. Using a larger equity risk premium will increase the expected returns for all risky investments, and by extension, reduce their value. Consequently, the choice of an equity risk premium may have much larger consequences for value than firm-specific inputs such as cash flows, growth and even firm-specific risk measures (such as betas).
Image of page 7
Image of page 8

You've reached the end of your free preview.

Want to read all 133 pages?

  • Spring '17
  • .........

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture