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The Market Risk Premium in Iceland What Is the Market Risk Premium for the Nasdaq OMX Iceland?

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The Market Risk Premium in Iceland What Is the Market Risk Premium for the Nasdaq OMX Iceland? Master of Science (MSc) in Corporate Finance The Market Risk Premium in Iceland What is the Market Risk Premium for the Nasdaq OMX Iceland? September 2019 Student: Kristján Jóhannesson Id. No.: 260990-3149 Supervisor: Már Wolfgang Mixa Acknowledgements I would first and foremost like to thank my supervisor Már Wolfgang Mixa for his help, guidance and support throughout the development of the thesis. I have really enjoyed our collaboration and our shared interest over the topic of the thesis has made the process of this research even more enjoyable. I also want to thank Nasdaq Iceland employees Kristín Jóhannsdóttir and Guðrún Özurardóttir, Snorri Jakobsson at Capacent and Brynjar Örn Ólafsson for providing me with the data necessary to perform the research. Finally, I would like to thank Davíð Jens Guðlaugsson, Johannes August Oskar Noerpel and Daníel Þór Magnússon for their time and effort reviewing the research and the thesis. 2 Abstract Market risk premium (MRP) is a key component in the cost of equity estimation. In foreign equity markets there have been a number of studies on the different types of the MRP. In Iceland the MRP has not been studied to the same extent. The studies that have been performed on the Icelandic market have been affected by the bubble phase period, 2004-20017, that ended with the collapse of the financial sector in 2008. That is why the focus in this research is going to be on the time period from 2010. The aim of this research is to determine the MRP for the Icelandic market. The following questions are going to be answered to determine the range of the MRP. 1. What is the historical MRP for the Icelandic market for the time period 2010 - 1st quarter 2019? 2. What is the implied MRP for the Icelandic market for the time period 2010 - 1st quarter 2019? 3. Are these estimates consistent with the MRP used by Icelandic market practitioners and MRP in other markets? The historical MRP was estimated using the OMXIGI index as a benchmark for the market returns. The proxy for the risk-free rate was the OMXI5/10YNI index. The geometric average is 6.72%. The standard error of the historical MRP is 4.13%. The implied MRP was estimated using three different methods: The discounted cash flow method on dividend yield and buyback yield for 2019, resulting in an implied MRP of 3.73%. Using country risk premium to estimate the range of the MRP in Iceland, using data from multiple markets, the range is 5.13% - 6.79%. The risk premium factor model was also implemented using the P/E ratio of the OMXI6/8 index. Resulting in an implied MRP of 6.08%. The result from the interviews are that CAPM is the preferred model to estimate the cost of equity. The range of the MRP between the interviewees is from 5% to 6.7%. Keywords: Cost of Equity, Market Risk Premium, Historical market risk premium, Implied Market Risk Premium, Risk Premium Factor, Iceland. 3 Declaration of Research Work Integrity This work has not previously been accepted in substance for any degree and is not being concurrently submitted in candidature of any degree. This thesis is the result of my own investigations, except where otherwise stated. Other sources are acknowledged by giving explicit references. A bibliography is appended. By signing the present document, I confirm and agree that I have read RU’s ethics code of conduct and fully understand the consequences of violating these rules in regards of my thesis. ............................................................................................................................................. Date and place Kennitala Signature 4 Table of Contents 1. Introduction .................................................................................................................. 9 2. Cost of Equity ............................................................................................................. 13 2.1 Forward Looking Concept ............................................................................................. 13 2.2 Discount Rate ................................................................................................................... 14 2.3 Relationship Between Risk and the Cost of Equity ...................................................... 15 2.4 Types of Risk .................................................................................................................... 15 2.4.1 Market Risk ............................................................................................................................... 15 2.4.2 Specific Risk ............................................................................................................................. 16 2.4.3 Other Risks ................................................................................................................................ 16 2.5 The Risk-Free Rate ......................................................................................................... 16 2.6 Methods to Estimate the Cost of Equity ........................................................................ 17 2.6.1 Build-Up Method ...................................................................................................................... 18 2.6.2 Capital Asset Pricing Model ..................................................................................................... 19 2.6.3 The Three Factor Model ........................................................................................................... 21 3. Market Risk Premium ................................................................................................ 23 3.1 Determinants of the Market Risk Premium ................................................................. 24 3.1.1 Risk Aversion and Consumption Preferences ........................................................................... 24 3.1.2 Economic Risk .......................................................................................................................... 25 3.1.3 Information ............................................................................................................................... 25 3.1.4 Liquidity and Fund Flows ......................................................................................................... 25 3.1.5 Catastrophic Risk ...................................................................................................................... 26 3.1.6 Government Policy ................................................................................................................... 26 3.1.7 Monetary Policy ........................................................................................................................ 26 3.1.8 The Behavioral/Irrational Component ...................................................................................... 26 3.2 Types of Market Risk Premiums ................................................................................... 27 3.3 Historical Market Risk Premium .................................................................................. 28 3.3.1 Studies on the Historical Market Risk Premium ....................................................................... 31 3.4 Implied Market Risk Premium ...................................................................................... 34 3.4.1 Determinants of Implied Market Risk Premium ....................................................................... 34 3.4.2 Implied Market Risk Premium Models ..................................................................................... 35 3.4.3 The Relationship Between Implied Market Risk Premium and Growth Expectations ............. 47 3.5 Survey on the Expected and Required Market Risk Premium .................................. 48 3.5.1 Studies on the Expected and Required Market Risk Premium ................................................. 48 3.7 The Equity Premium Puzzle ........................................................................................... 50 4. Research ..................................................................................................................... 51 4.1 Time Period ...................................................................................................................... 51 4.2 Proxy for The Risk-Free Rate ........................................................................................ 52 4.3 The Research on Historical Market Risk Premium ..................................................... 54 4.4 The Research on the Implied Market Risk Premium .................................................. 56 4.4.1 Discounted Cash Flow Model-Based Premium ........................................................................ 58 4.4.2 Default Spread Model Based Premium ..................................................................................... 60 4.4.3 Risk Premium Factor Implied Market Risk Premium Model ................................................... 62 4.5 Interviews ......................................................................................................................... 63 4.5.1 Participants ................................................................................................................................ 64 4.5.2 Data Process .............................................................................................................................. 64 5 5. Results from the Research ........................................................................................
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