FINA 410 - Risk Free and Equity Risk Premium

Requirements for an Asset to be risk-free

An asset is risk-free if the actual return is always equal to the expected return, with the following conditions:

1. There is no default risk (no security issued by a private equity)

2. No reinvestment risk. When calculating the risk-free rate over 10 years, you cannot use shorter maturity govt bonds because we do not know the rate at which we can reinvest

Consistency Principal

Risk free rate used should be measured consistently with ohw cash flows are measured

Nominal Interest Rate

Growth rate of your money

Real interest rate

Growth rate of your purchasing power

Under conditions of high and unstable inflation, valuation is often done in _____ terms

real

Real risk-free rates in other countries can use the USTIPS real risk-free rate if ______________________________, otherwise, _____________ should be equal to ____________

capital flows freely to those economies…the long-term expected real risk-free rate ….. the expected real long-term growth rate of the economy

What if the government is perceived to have a risk of default?

The local treasury bond rate contains two components:
1. the Risk free rate and 2. the compensation for expected default risk

How do you examine the risk-free rate?

Examining rating agenies’ local currency sovereign rating

If the ratings are Triple A, then the government bond rate is the ______

risk-free rateIf

If the ratings are not Triple A, then the foreign bond rate reflects:

the risk free rate + default rate risk

Equity Risk Premium

Risk matters, riskier investments should have a higher expected return than safer investments to be considered good investments

3 ways of measuring the risk premium

1. Historical

2. Modified Historical

3. Implied Equity Premium methods

Historical Risk Premium

The actual returns earned on stocks over a long period of time are estimated, and then compared to the actual returns on a risk-free security - the difference is the risk premium, on an annual basis

Choice of risk-free security

The risk-free rate chosen in omputing the premium has to be consistent with the risk-free rate used to computed expected returns

Arithmetic Average

Measures the simple mean of the series of annual returns

Geometric Average

Looks at the compounded return

Downside of arithmetic averages

Will overestimate the risk premium

Best practices when using the historical approach to compute the equity risk premium

Choosing a longer time period, T-Bonds (10-yr) as the risk free rate, and the geometric average

Midified Historical Risk Premium

Equity Risk Premium (country) = Equity Risk Premium (Mature Market) + Country Risk Premium

To measure the country risk premium (CRP), we consider 3 approaches:

i. Default Bond Spreads

ii. Equity Market Volatility

iii. a Blended approach

Implied Equity Premiums

Alternative to historical methods for country risk, we want to solve for the expected rate of return in a DCF model, where the value of equity represents the value of the entire market