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

Summary

In this corporate finance class session, the focus is on understanding the equity risk premium (ERP), the additional return investors demand for investing in stocks over risk-free assets. The session covers various approaches for estimating ERP, including surveys of investor expectations, historical data comparisons, and forward-looking models. It also highlights the challenges and variability in these estimates, particularly the influence of market conditions. Lastly, the session explores how to estimate country-specific ERP by adjusting for sovereign risk and the relative volatility of equities in different markets.

Takeaways

• 😀 The equity risk premium (ERP) is the additional return an investor demands for investing in a risky asset compared to a risk-free asset, such as T-bonds or T-bills.
• 😀 The ERP varies depending on individual risk aversion, which is influenced by factors like age and gender. Younger people tend to be less risk-averse than older people, and men are typically less risk-averse than women.
• 😀 In an experiment, the question of how much more than a guaranteed risk-free return (e.g., 3%) investors would demand to invest in stocks reflects their risk aversion. This varies widely among individuals.
• 😀 Equity risk premiums are dynamic and change based on market conditions. For instance, if the market drops, some investors may demand a higher premium, while others may accept a lower one due to the perceived opportunity in a lower market.
• 😀 There are three main ways to estimate the equity risk premium: surveys, historical data, and forward-looking estimates. Each method has its strengths and limitations.
• 😀 Surveys of subsets of investors (e.g., portfolio managers, CFOs) often reflect past performance and can be volatile, making them less reliable for predicting future ERPs.
• 😀 The historical equity risk premium is calculated by comparing long-term average returns on stocks to those of risk-free assets (like T-bonds or T-bills) over a specific historical period. These premiums can vary significantly based on the time frame and the type of government securities used.
• 😀 A significant challenge in using historical data is the large standard error associated with these estimates. For example, a 4.62% premium could have a standard error of 2.3%, indicating a high level of uncertainty in the estimate.
• 😀 When estimating equity risk premiums for markets outside the US, practitioners often add the sovereign default spread to the US ERP to account for country-specific risks. This is done when historical data is insufficient.
• 😀 The scaling of sovereign default spreads for equity risk is based on the relative volatility (standard deviation) of equities versus government bonds. Equities are typically riskier, and their default spreads are adjusted accordingly to reflect this additional risk.

Q & A

What is the equity risk premium, and why is it important in finance?

The equity risk premium is the additional return an investor demands for investing in a risky asset (like stocks) compared to a risk-free investment (like government bonds). It is important because it compensates investors for taking on the extra risk associated with equities.

What are the main factors that influence an individual's equity risk premium?

The main factors include the investor's risk aversion and personal circumstances, such as age and gender. Generally, younger individuals and men tend to be less risk-averse, while older individuals and women tend to be more risk-averse.

How can the equity risk premium change due to market conditions?

The equity risk premium is dynamic and can shift based on external market conditions. For instance, if the market drops significantly, investors might demand a higher risk premium due to perceived increased risk, or they might accept a lower premium if they believe stocks are undervalued.

What are the three primary methods to estimate the equity risk premium?

The three primary methods are: (1) Surveys of investor expectations, (2) Historical data (looking at past returns on equities versus risk-free assets), and (3) Forward-looking models that attempt to predict future premiums based on current economic conditions.

What are the limitations of using surveys to estimate the equity risk premium?

Surveys are often unreliable because they reflect investor sentiments based on past performance rather than future expectations. They can also be volatile and influenced by recent market trends, leading to biased estimates.

What is the difference between arithmetic and geometric averages in estimating equity risk premiums?

The arithmetic average simply sums up returns over a period and divides by the number of periods, while the geometric average accounts for compounding over time. Geometric averages are generally more appropriate for estimating long-term returns as they reflect the compounding effect.

Why is it suggested to use long historical data when estimating equity risk premiums?

Using long historical data (e.g., from 1928 onwards) helps minimize the statistical error associated with shorter time periods. Longer data sets provide more reliable estimates of the equity risk premium, as they encompass more market cycles and broader economic conditions.

How can historical data from other countries be used to estimate equity risk premiums?

For countries with limited historical data, a common approach is to add the sovereign default spread (the difference between the country's bond rate and a risk-free rate) to the U.S. equity risk premium, adjusting for the relative risk of equities compared to government bonds in that country.

What is the significance of scaling the sovereign default spread when estimating equity risk premiums in foreign markets?

Scaling the sovereign default spread is important because equities are typically riskier than government bonds. By adjusting for the higher volatility (standard deviation) of equities compared to bonds, the equity risk premium is more accurately reflected for each country.

What role does risk aversion play in determining an individual’s equity risk premium?

Risk aversion directly impacts the equity risk premium. More risk-averse investors will demand a higher premium to compensate for the potential volatility of equities, while less risk-averse investors may accept a lower premium for the same risky investment.