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.

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.

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

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. Results from the Research ...... 66 5.1 Results on the Historical Market Risk Premium ...... 66 5.2 Results on the Implied Market Risk Premium ...... 67 5.2.1 Results on the Discounted Cash Flow Model-Based Premium ...... 67 5.2.2 Result on the Default Spread Method ...... 69 5.2.3 Results on the Risk Premium Factor Implied Market Risk Premium Model ...... 72 5.3 Results from the Interviews ...... 75 5.3.1 Magnús Gunnar Erlendsson KPMG Partner and Valuation Specialist ...... 75 5.3.2 Snorri Jakobsson Capacent Research Department Manager Expert ...... 77 5.3.3 Þorsteinn Andri Haraldsson Equity Analyst at Arion Bank ...... 78 6. Conclusion and Discussions ...... 80 6.1 Conclusion on the Historical Market Risk Premium ...... 80 6.2 Conclusion on the Implied Market Risk Premium ...... 82 6.2.1 Conclusion on the Discounted Cash Flow Model Based Premium ...... 82 6.2.2 Conclusion on the Default Spread Method ...... 83 6.2.3 Conclusion on the Risk Premium Factor Implied Market Risk Premium Model ...... 85 6.3 Conclusion on the Interviews ...... 88 6.4 Overall Conclusion on the Market Risk Premium in Iceland ...... 89 Bibliography ...... 91 Appendix 1 – The Annual Yield on the Proxy for the Risk-Free Rate ...... 97 Appendix 2- The Annual Returns on the OMXIGI and OMXIPI ...... 98 Appendix 3 – Nasdaq Price Return Index Calculation ...... 99 Appendix 4 - Nasdaq Gross Total Return Index Calculation ...... 100 Appendix 5 - Companies in the OMXI6/8 Index from January 2010 ...... 101 Appendix 6 – The Interview Guide ...... 102

List of Figures

Figure 1. U.S. Default Spread vs. S&P500 Implied- and Historical Market Risk Premiums from 2010-2018 ...... 40 Figure 2. Implied Market Risk Premium for S&P500 using the Risk Premium Factor from 1990-2009...... 46 Figure 3. Implied Market Risk Premium for S&P500 using the Risk Premium Factor from 2010-2019 ...... 47 Figure 4. Annual returns on OMXIGI, OMXIPI and OMXI8GI equity indexes from 2010-2019...... 52 Figure 5. Yields on 5 and 10-year non-indexed government bond index from 2010- 2019...... 53

Figure 6. Annual returns for OMXIGI and OMXIPI equity indexes including the yield on the OMXI5/10YNI ...... 55 Figure 7. P/E Ratio of the OMXI6/8 from 2010-2019 ...... 58 Figure 8. Fluctuation of the variables in the Risk Premium Factor model for the time period ...... 72 Figure 9. RPF Implied Market Risk Premium correlation with the Risk-Free Rate ...... 73 Figure 10. Regression statistics for RPF factor using data from 2010-2019 ...... 74 Figure 11. Annual Returns of the OMXIGI vs. the Annual Returns of the proxy for the Risk-Free Rate...... 81 Figure 12. Relationship between market risk premium and E/P ratio in the RPF model86 Figure 13. Monthly volatility of the Risk Premium Factor ...... 88

List of Tables Table 1. Historical Market Risk Premiums for two time periods, 1900-2010 and 1900- 2017...... 32 Table 2. Historical Market Risk Premium from 1976-2002...... 33 Table 3. Damodaran Implied Market Risk Premium for the S&P500 index from 2010- 2019 ...... 37 Table 4.Fenebris Implied Market Risk Premium for 19 countries using geometric average for the time period 2010-2019...... 37 Table 5. Country Risk Premium-based Market Risk Premium for 2019 ...... 41 Table 6. Required Market Risk Premium around the world via survey, 2019, -18, -17 and -15 ...... 49 Table 7. Constituents of fixed income indexes for the research period...... 54 Table 8. Dividend yield on the OMXI8 index 2010-2018 ...... 59 Table 9. Growth expectations from the Monetary Bulletin from the Central Bank of Iceland...... 63 Table 10. Historical Market Risk Premium based on annual returns from 2010 - 1st quarter of 2019...... 67 Table 11. Cash to Investors for the OMXI8CAP Index 2019 ...... 68 Table 13. Discounted Cash Flow Model for OMXI8CAP April 1, 2019...... 68 Table 14. Base Premiums for mature equity markets with a Aaa Moody's credit rating 2019...... 70

Table 15. Possible MRP for Iceland using Default Spread on top of base premium from various countries...... 71 Table 16. Possible MRP for Iceland using Default Spread multiplied with the volatility of emerging equity markets...... 71 Table 17. Annual Average Implied Market Risk Premium from the RPF model...... 73 Table 18. RPF Market Risk Premium for Iceland 2010-2019 ...... 74 Table 19. Highlighted Premiums using Default Spread Method ...... 84 Table 20. Highlighted Premiums using Default Spread multiplied with the volatility of emerging equity markets ...... 85

1. Introduction Market risk premium is a key term in the world of finance and is frequently used in various fields of financial calculations, especially in corporate finance and valuation. The definition of market risk premium can be described as the measurement of risk that market participants require to participate in the equity market. When investors choose to invest in riskier investments, they need to be compensated with higher returns due to expected volatility in comparison to assets defined as being risk-free. Otherwise, investors would simply put their money in risk-free assets such as government bonds. The additional compensation that investors receive for participating in the equity market has various definitions such as risk premium, equity premium, market risk premium or equity risk premium. For simplicity measures, it is defined in this research as market risk premium (MRP).

There is a common understanding between academics and practitioners that the MRP increases in bear markets and decreases in bull markets (Dimson, Marsh, & Staunton, 2011). When there is increased risk in the equity markets investors demand a higher compensation for participating in the equity market and vice versa when risk in the equity market decreases. The MRP is a forward-looking concept usually built on historical or current data. In general, it can be difficult or even impossible to predict with any precision what is going to happen in the future; the same applies to the equity market. To obtain still the best approximation for the MRP, it is often beneficial to examine it from different perspectives using different methodologies. The MRP is not a constant for all equity markets, in fact the MRP is different between markets, time periods and different types of MRP can yield different results.

The role that MRP plays in cost of equity estimation makes it one of the most important numbers in finance. It can have negative consequences to overestimate the MRP. A high MRP will translate into a higher cost of equity when using the capital asset pricing model (CAPM). A higher cost of equity will then lead to a higher weighted average cost of capital (WACC). A higher WACC could lead practitioners into rejecting good projects because of negative net present value. As a result of the future cash flow of the project is discounted with an overestimated company cost of capital on the equity side. A too low MRP would have the opposite effect, leading to the acceptance of bad projects because of positive net present value that should not be created in calculations.

There have been a number of studies on the different types of MRP. Dimson, Marsh and Staunton studies are common sources when it comes to historical MRP statistics. They have a database on returns for a number of countries from 1900 that is updated annually. The historical premium for the U.S. market is 4.40% based on returns from 1900-2017 relative to long-term government bonds according to their database (Dimson, Marsh, & Staunton, 2018). Damodaran is possibly the most authoritarian figure in finance in regard to MRP and other inputs in the related capital asset pricing model (CAPM). He annually updates his estimate on the implied MRP for the S&P500 index, his estimate for 2019 being 5.96% (Damodaran A. 2., 2019). Damodaran also estimates MRP for a number of countries by adding a country risk premium on top of his implied premium for the S&P500 index. Fernandez is another productive academic when it comes to MRP. He conducts surveys to estimate the required MRP for various markets, currently estimating the MRP for U.S. market at 5.60% (Fernandez, Martinez, & Acín, 2019).

Estimating the MRP is subjective. Case in point is that after just looking at 3 different estimates of the premium for the U.S. market the scope of the MRP is already ranging from 4.40% to 5.96%. Awareness to the different types of MRP and how the numbers are calculated is vital when choosing a relevant risk premium in financial calculations.

Studies on MRP for the Icelandic market are almost nonexistent. Benedikt Sigurðsson estimated both the historical MRP for the Icelandic market for the time period 1998-2017 as well as the implied MRP for the same time period. His results showed that the historical premium for that time period was -10.1% and the implied premium was 4.3% (Sigurðsson, 2019). Damodaran´s estimate for Iceland using country risk premium for 2019 is 7.63% (Damodaran A. 1., 2019). The range for the Icelandic market is thus considerably higher than for the U.S. market, which is understandable in light of the rise and fall of the Icelandic stock market during the period Sigurðsson investigated.

Estimating the MRP for the Icelandic market is an interesting subject, since the history of the Icelandic stock market can be best described as extreme. The Icelandic stock market, Nasdaq OMX Iceland, is a young stock exchange with not many listed companies in international comparison. Participation of the general public in the stock exchange is low, more precisely only 5% throughout the research period, compared to for example 11% in Europe (Jónsdóttir & Gústafsdóttir, 2019). Because of the small size and the trading volume on the Nasdaq OMX Iceland, there have only been two studies on the

10 efficiency of the market as well as the validity of the CAPM model for the Icelandic market. Both researches were done by Stefán B. Gunnlaugsson. In his research on the validity of the CAPM model for the Icelandic market using data from 1999 – 2004 he concluded that the CAPM worked well for the small Icelandic stock market (Gunnlaugsson, 2007). The other study on whether the Icelandic market could be considered weak form efficient, using data from 1993-2017, Stefán B. Gunnlaugsson concluded that the market is not weak form efficient and consequently inefficient (Gunnlaugsson, 2018).

Despite the inefficiency of the Nasdaq OMX Iceland, market practitioners and government institutions use CAPM in their cost of equity calculations. A lack of study on the MRP for the Icelandic market has led practitioners to look to other markets for estimates on the MRP.

The Nasdaq OMX Iceland is marked with astronomical profit and losses that occurred over a 3-year, bubble phase, period from 2004-2007 only for the stock market to almost be wiped out in 2008 (Mixa & Sigurjónsson, 2010). The bubble phase period has proved problematic for the estimation of the MRP like Benedikt Sigurðsson encountered. In the closing remarks of his research, Sigurðsson concludes that the quality of data for the time period 1998 – 2009 is insufficient and studying the time period from 2010 should be done in future researches on MRP (Sigurðsson, 2019). Studying shorter time periods, 10 years, also gives the researcher a good estimation of the current risk-aversion among investors. The MRP in Iceland has not been examined specifically from 2010. These are the reasons why the focus of this research is going to be on the time period from 2010 to the 1st quarter of 2019.

The review of the MRP in this thesis is split into 6 chapters.

Chapter 2 includes a literature review where the MRP is put into the context of cost of equity estimation. The chapter begins describing the nature of cost of equity as a forward- looking concept and the role that it plays in present value calculations. Then the relationship between risk and cost of equity is analyzed together with the different types of risk equity investors are confronted with in their investments. The relevant risk-free rate for cost of equity calculations is reviewed. Finally, the models that are most used by academics and market practitioners are reviewed.

In chapter 3 an in-depth literature review is performed on the MRP. The chapter starts with an overview of the different determinants of the MRP. Then the different types of MRP are outlined before a more detailed look is taken on each of them. The main literature on the historical, implied, required and expected MRP is summed up and then the relevant MRPs for a number of countries are highlighted. Chapter 3 ends with a discussion on the equity premium puzzle.

Chapter 4 outlines the research methods. It begins with a coverage on the time period used followed with an overview of the proxy for the risk-free rate in the research. Then the research method for the historical MRP is outlined. The implied MRP is estimated using three different approaches. Interviews are then conducted to answer research question number 3.

Chapter 5 presents the results from the different research methods. Beginning with the historical MRP, continuing with the implied MRP. Finally, the interviews are reported.

Chapter 6 focuses on the conclusion and discussion on the findings in this research, first separately for all the methods covered in this thesis and then an overall conclusion on the MRP in Iceland.

2. Cost of Equity Market risk premium on its own does not tell us much except what the risk aversion is for the average investor. When the MRP is put into context of cost of equity estimations it becomes one of the most important numbers in finance. MRP is a vital component in cost of equity calculations. To gain a better understanding of the MRP it is important to study it from the perspective of cost of equity. In the following chapter a light will be shed on the relationship between the cost of equity and the MRP.

The cost of equity is the opportunity cost of capital and in that sense related to the economic principle of substitution. When an investor has put his money in an investment, he cannot put that money in other investments. Definitions of cost of equity and cost of capital are often very similar. There is, however, a fundamental difference between them. The cost of equity, like the name suggest, is only the expected return on an equity investment in a firm. The cost of capital is on the other hand the expected return on both equity and debt investments in the firm, often referred to as the weighted average cost of capital (WACC) (Brealey , Myers, & Allen, 2017). The two terms go hand in hand in a way that to be able to determine the WACC one has to proportionally estimate the cost of equity first and then the cost of debt.

2.1 Forward Looking Concept Both cost of capital and cost of equity are forward looking concepts that define investors’ expectations. According to Shannon P. Pratt and Roger J. Grabowski there are two elements to these expectations: 1. The risk-free rate: The rate of return that investors are ready to let someone else use their money on a risk-free basis excluding inflation. The risk-free rate is sometimes referred to as the “real” rate of return. 2. Risk: The probability investors take on possibly not receiving all the expected cash flow or other economic income on an investment.

The combination of the risk-free rate and risk is sometimes referred to as the time value of money (Pratt & Grabowski, 2008). Time value of money simply states that: a dollar today is worth more than a dollar tomorrow. Getting a dollar today would give us the opportunity of collecting interest. With that knowledge it is possible to calculate both the future value and the present value of a dollar received today or tomorrow (Brealey ,

Myers, & Allen, 2017). Present value in the context of cost of equity refers to the dollar amount that a rational and well-informed investor would be willing to pay today for an expected later future cash flow. It is more common for the cost of equity to be presented in nominal terms, because it states the expectations of the market and as a result also includes expected inflation (Pratt & Grabowski, 2008). By excluding the expected inflation cost of equity would then be estimated in real terms. On the knowledge on present value Reilly and Brown built the theory of valuation:

“The value of an asset is the present value of its expected returns. Specifically, you expect an asset to provide a stream of returns during the period of time you own it. To convert this estimated stream of returns to a value for the security, you must discount this stream at your required rate of return. This process of valuation requires estimates of: (1) the stream of expected returns and (2) the required rate of return on the investment, its discount rate” (Reilly & Brown, 2012).

2.2 Discount Rate For a company, investor, analyst or academic to estimate if a certain investment decision is a good or bad one, he or she will need a discount rate to find the net present value from future cash flows. According to the net present value rule investors accept investments that have positive net present value. The discount rate includes both the time value of money and risk and is thus equal to cost of capital. If a project is equity financed, then the cost of capital equals the cost of equity. To calculate the cost of capital when a project is financed both with equity and debt the WACC formula is used: �� = �� ∗ ∗ �� ℎ�� + �� ∗ Where: D = Market value of debt E = Market value of equity V = Total market value; D + E

The WACC formula looks at both the cost of debt and cost of equity when estimating the cost of capital for a company or a project. The weight of the cost of equity in WACC calculations depends on the capital structure of the firm or the project. If the project or the firm is only equity financed, then WACC equals the cost of equity. Estimating cost of equity is a big part of the WACC calculation and the most demanding one and can be highly subjective. 14

2.3 Relationship Between Risk and the Cost of Equity Well-informed investors usually do not take on risk simply for the fun of it. They demand a higher return for investments that include higher risk. Because investors require a premium for risk, the cost of equity and in fact the cost of capital, for all types of investments, are derived from these two factors: 1. A risk-free rate: Defined as the rate of return on an investment that doesn’t have default risk. Typically, a short-term government bond. 2. A premium for a risk: The additional rate of return investors demand over the risk-free rate when the investment includes capital risk, e.g. stocks.

According to Pratt and Grabowski the generalized cost of capital relationship is described with the following formula: �(��) = �� + �� Where: E(Ri) = Expected return on security i Rf = Risk-free rate RP = Risk premium for security i

The formula applies to both equity and fixed income investments. The biggest factor in estimating cost of equity is to estimate the risk of the investment or the company (Pratt & Grabowski, 2008). To be able to estimate the risk premium in equity investments an investor must know the MRP, assuming that one of these methods is used to calculate the cost of equity: Build-up method, CAPM or the three-factor model. A more detailed review of those models will take place later in this chapter.

2.4 Types of Risk To understand the MRP, it is vital to understand the different types of risks that investors are faced with in the equity market. According to portfolio theory there are two types of risk that affect all firms. One of them is called market risk and cannot be eliminated with diversification. The other is called specific risk and can be eliminated with diversified portfolio. Let’s take a closer look into these two risk factors.

2.4.1 Market Risk Market risk, also referred to as systematic risk or undiversifiable risk, is a risk factor that cannot be avoided through diversification. The reason why market risk is unavoidable is 15 because it is a risk inherent to the market that all companies have in common, hence it is also called undiversifiable risk. The correlation between market risk and the companies creates the trend of stocks moving together. There are other risk factors that affect companies individually. In CAPM and other methods to estimate the cost of equity the beta is used to measure the sensitivity to the market risk (Bodie, Kane, & Marcus, 2014).

2.4.2 Specific Risk Specific risk, also referred to as unsystematic risk, residual risk, unique risk or diversifiable risk, is on the other hand a risk factor that can potentially be avoided with diversification. The reason why it can be avoided is because this risk factor is tied to the individual company or an industry and not the market as a whole. To capture the specific risk in cost of equity estimations a size premium is commonly used and will be discussed in more detail later in the chapter (Brealey , Myers, & Allen, 2017).

2.4.3 Other Risks Portfolio theory assumes that markets are efficient. In Iceland Stefán B. Gunnlaugsson has examined and concluded that the Icelandic market cannot be considered weak form efficient and is therefore inefficient (Gunnlaugsson, 2018). When markets are inefficient other risk factors come in, such as market prices can be incorrect, and investments can be illiquid (Pratt & Grabowski, 2008).

2.5 The Risk-Free Rate The risk-free rate has previously in this chapter been described as “the rate of return that investors are ready to let someone else use their money on a risk-free basis excluding inflation” and “the rate of return on an investment that does not have default risk. Typically, a short-term government bond”. Usually government bonds are issued with different maturity dates from e.g. one year, five-year, ten-year, twenty year to thirty years. This leaves us with the question what type of government bond should be used as the proxy for the risk-free rate in our cost of equity estimations?

The duration and interest on government bonds vary. Simple logic would suggest that the government bond with the shortest maturity time (treasury bills) would be best positioned to represent a risk-free rate, because of the guarantee of getting the money back. But treasury bills create another type of risk, reinvestment risk if the investment horizon is longer than one year. When looking at the duration of company’s cash flows a long-term 16 government bond, 10 year matches much better than short term bonds (Koller, Goedhart, & Wessels, 2015). When choosing a risk-free rate for cost of equity estimations using the build-up method or the CAPM model (a more detailed discussion about those models will take place in the next chapter) the maturity of the government bond has to match two factors. The first one being that the risk-free rate has to have the same maturity as the expected duration of the cash flows of the business, asset or project being valued. The second factor is that the risk-free rate used to estimate the MRP is consistent with the one used in cost of equity calculations. Duff & Phelps assess that the most common maturities on the U.S. government bonds used as a proxy for the risk-free rate by practitioners are 10 and 20 years. The main reason why longer-term government bonds are preferred over the shorter-term government bonds is because the maturity on the long-term bonds matches better the investment horizon, duration of cash flows and risks that businesses are confronted with (Duff & Phelps, 2016).

Pratt and Grabowski state that the risk-free rate usually consists of long-term government bond. The main reason why long-term government bond is preferred is because it resembles company investments more than short term government bond. The reinvestment risk and long duration are the two factors that most investments and long- term government bonds have in common. Another factor that supports the usage of long- term government bonds is the consistency it gives to the MRP. It matches both the investments horizon and risk represented in the MRP (Pratt & Grabowski, 2008).

Another factor that is crucial to take into consideration is whether the government bond is index-linked or not. If a practitioner uses a non-index linked government bond, then he is obtaining the nominal MRP that includes the expected inflation. However, if practitioner uses an index-linked government bond, he must then also deduct inflation from the returns on the stock market to get the real return. Calculating MRP on nominal or real terms should not have a great impact on the final result as both estimates should give roughly the same premium (Damodaran A. 2., 2019).

2.6 Methods to Estimate the Cost of Equity In the WACC formula, introduced in chapter 2.2, the cost of equity is the component that is most demanding to estimate. There is no universally accepted method to determine the cost of equity among practitioners and academics. The two financial crashes taking place

17 in the previous decade, the dot com crash 2001 and the financial crises of 2008, have made the estimation of a key ingredient, the risk premium, a more difficult task (Koller, Goedhart, & Wessels, 2015).

Three methods of the four that are going to be introduced, build-up method, CAPM and the three factor model, share the principle of having to estimate one or more components of a risk premium and then add the total risk premium to the risk-free rate to be able to determine the cost of equity (Pratt & Grabowski, 2008). The fourth method, arbitrage pricing theory, is very different from the other three. Arbitrage pricing theory assumes that stock returns are a mixture of factors and noise that are unique to individual companies (Brealey , Myers, & Allen, 2017).

In the following subchapters a brief introduction into those three different methods will be conducted to put the MRP in context with cost of equity estimations. Since arbitrage pricing theory does not rely on the market portfolio and in practice the implementation of the model has been complex. In fact, Koller, Goedhart and Wessels claim that arbitrage pricing theory is mainly used in the classroom (Koller, Goedhart, & Wessels, 2015). Arbitrage pricing theory is for that reason not going to be covered in the following subchapters.

2.6.1 Build-Up Method The build-up method in its basic form only consist of two components, the risk-free rate and a risk premium. The risk premium is however divided into three different subcomponents. A general MRP, a small company premium and a company specific risk premium.

The formula for the build-up method is: �(��) = �� + �� + �� + �� Where: E(Ri) = Expected rate of return, cost of equity Rf = Return on a risk-free security MRP = Market risk premium RPs = Small-company premium RPu = Risk premium related to specific risk, either the company or the industry

Like previously stated, the risk-free rate is defined as the rate of return on an investment that doesn’t have default risk. In cost of equity estimations, the risk-free rate usually consists of long-term government bond.

The MRP is the next variable to be estimated in the model. For a company that has not a substantial a small company premium or a company specific risk premium, the MRP could be proportionally the highest number in the equation. Getting the MRP right is vital for the calculations using the build-up method. A more detailed discussion about the MRP will take place in the next chapter.

According to studies smaller companies face a greater degree of risk and consequently have a higher cost of equity. To account for this greater risk many practitioners use the spread between returns on small company stocks and large company stocks as the small company premium (RPs) (Pratt & Grabowski, 2008).

The specific risk factor premia (RPu) is estimated for each company risk characteristics. Usually the estimation is made from the analysis of the following five factors (Pratt & Grabowski, 2008): 1. Size smaller than the smallest size premium group 2. Industry risk 3. Volatility of returns 4. Leverage 5. Other company-specific factors

2.6.2 Capital Asset Pricing Model The most widely used method to estimate cost of equity is the capital asset pricing model, simply known as the CAPM. Around 73% of managers surveyed by J.R. Graham and C.R. Harvey claimed to use CAPM to estimate cost of equity (Graham J. a., 2001). The main difference between the CAPM and the build-up method is the introduction of beta to estimate the company sensitivity to the market risk. A fundamental assumption in the CAPM model is that the only risk that investors care about is the one they cannot avoid, the market risk. Specific risk is for that reason not included in the CAPM model. The model assumes that investors manage specific risk through their own diversification.

The formula for CAPM: �� = �� + �* ��. 19

Where: CAPM = Cost of equity Rf = Risk-free rate � = Beta value MRP = Market risk premium

The same principle applies to the risk-free rate in the CAPM model as in the build-up method. When financial managers use CAPM to find a discount rate for their project the risk-free rate has to have a similar maturity as the project that is being evaluated.

Like the MRP, the beta is a forward-looking concept but relies on past data to estimate it. The beta measures the market risk of an investment by the degree to which the value of the investment has an effect on by a change in the combined value of all the assets in the economy. In other words, the beta estimates the volatility of the excess returns for a listed company relative to the market. Again, like when estimating the historical MRP, past returns are used as a benchmark and regressed against the returns of a defined market. According to portfolio theory, risk free assets have a beta of 0 and the market portfolio has a beta of 1. Stocks that have a beta lower than 1 are characterized as conservative stocks with lower market risk that the market. On the opposite end stocks with higher beta than 1 are described as aggressive and have a higher market risk that the market portfolio (Brealey , Myers, & Allen, 2017).

After estimating the beta for a company, the beta is multiplied with the MRP to determine the exposure that the company has to the market risk factor, the MRP.

It is possible to expand the CAPM model to also cover the specific risk by adding two factors to the formula, the same two as in the build-up method (Pratt & Grabowski, 2008): �� = �� + � ∗ �� + �� + �� Where: Expanded CAPM = Cost of equity Rf = Risk-free rate � = Beta value MRP = Market risk premium RPs = Small-company premium RPu = Risk premium related to specific risk, either the company or the industry

This expanded version of the CAPM model has been used by Icelandic market participants to estimate the cost of equity for Icelandic companies. For the specific risk premium, the currency risk is the biggest risk factor among Icelandic companies (Greiningardeild Landsbanka Íslands, 2003).

The CAPM model has its critics, Pablo Fernandez wrote a paper and a chapter in the book Economic Ideas You Should Forget, where he claims that the CAPM is an absurd model based on assumptions that have no basis in the real world. The assumptions Fernandez criticizes are the beta and the MRP. He names a number of problems associated with the calculated beta, for instance how it depends on the stock index used as a proxy for the market as well as the time period used. The biggest error related to the MRP is when practitioners assume that it is a variable for the market but not different between investors1 (Fernandez, 2015).

Stefán B. Gunnlaugsson conducted a research on the validity of the CAPM model for the Icelandic market using data from 1999 – 2004 he confirmed that the CAPM worked well for the small Icelandic stock market (Gunnlaugsson, 2007).

2.6.3 The Three Factor Model Eugene Fama and Kenneth French concluded in the paper “The Cross-Section of Expected Stock Returns”, published in the Journal of Finance 1992, that equity returns are reversely related to the size of company’s market capitalization and positively related to the ratio of a company’s book value to its market value of equity (Fama & French, 1992). This is the foundation of the Fama-French three factor model, where stock’s excess returns are regressed on a number of factors, the market factor, size factor and the book- to-market factor to estimate the cost of equity.

The formula for the three-factor model is: �(��) = �� + � �� (� �� ) + � �� (� �� ) + � �� − �� − �� (� �� − �� − �� ) Where: E(Ri) = Expected return, cost of equity Rf = Risk free rate

1A detailed discussion on the diffrent types of market risk premiums takes palce in chapter 3.2. 21

Market factor = Return on market index minus risk free rate, effectively the market risk premium. Size factor = Return on small-firm stock less return on large-firm stocks Book-to-market factor = Return on high book-to-market ratio stocks less return on low book-to-market-ratio stocks.

After identifying the factors, the second step is to estimate the MRP for the market factor.

The third and last step is to estimate the factor sensitivity. Different stocks have different exposure to the fluctuations in returns on the three factors. That reason makes it crucial to estimate the sensitivity before multiplying each of the factors together to estimate the cost of capital.

When the CAPM and the three-factor model are compared by calculating the cost of equity for different sectors the three-factor model produces lower cost of equity estimate for growth sectors and a higher estimate for value sector than the CAPM model. The main reason for the difference between the two methods is the exposure to the book-to-market factor between sectors in the three-factor model (Brealey , Myers, & Allen, 2017). In theory the build-up method, CAPM and the three-factor model should all estimate same cost of equity for a firm.

3. Market Risk Premium After reviewing the main methods to calculate the cost of equity it is clear that the MRP is a key component. Because of the importance of the MRP in the cost of equity estimation, the MRP plays a big role in corporate finance, equity analysis, valuation and portfolio management.

The definition of MRP is dependent on the methodology used to estimate it. The most common definition is the one used in the CAPM model: �� = �� − �� Where: �� = The expected market returns. �� = The interest rate on a risk-free security. In other words, MRP is the expected return investor would get for participating in the stock market above the risk-free rate.

Another definition used in the research to estimate the implied MRP is: �� = �� ∗ �� Where: Rf = The interest rate on a risk-free security. RPF = Risk Premium Factor The risk premium factor is calculated and multiplied with the risk-free rate, from the assumption that investors seek a MRP as a portion of the risk-free rate.

Gylfi Magnússon conducted a study on the effect of the 2007-2009 financial crises on the MRP, both in Iceland and in other countries. Magnússon measured the drop-in value from the highest value before the crises to the lowest after the crises for both the OMXIPI and OMXIGI indexes in US dollars, the drop was 97,7% for both indexes. (Magnússon, 2016). This extreme drop in value on the OMX Iceland stock exchange has proved problematic for academics and practitioners to estimate the MRP in Iceland2. Because of these problems the time-period examined in the research chapter is going to be from 2010, the time period posts the financial crises.

Because MRP is a forward-looking concept there are several ways to determine the MRP. The most common way is to look at historical returns for the market as a whole, for best

2 A further discussion about these problems is going to take place later in chapter 3 23 estimate looking at data for as long period back as possible. This method isn’t flawless and will be discussed further in the historical market risk chapter. The second method is to estimate the cost of equity for the market based on the current share price and performance indicators of a large sample of companies. By doing so an implied MRP will be found that reflects the expectations of the market. The third and last method involves surveys, simply asking the market participants, investors, managers and academics, what the estimate to be the expected return on the market. In this research interviews are going to be conducted to get a rough estimate for the expected and required MRP and also shed light on how cost of equity calculation is done by practitioners in Iceland.

MRP is the price that a risk averse investor puts on risky cashflows. When MRP increases investors are demanding a higher compensation for a risk, that will result in lower prices for the discounted cash flow for the investment. The reason why MRP affects future cash flows is because of its influence on the discount rate, covered in chapter 2.2. The MRP is a market wide number that focuses on the market risk. The choice of a MRP can have a much larger effect on value calculation than other estimation factors such as cash-flows, growth or firm-specific risk measures, e.g. beta (Damodaran A. 2., 2019).

3.1 Determinants of the Market Risk Premium To gain a deeper knowledge of the MRP this chapter will break the MRP down to pieces and examine the components that it includes. Aswath Damodaran has put together a list of factors that determines the MRP. A brief overview of these factors is going to take place in this chapter.

3.1.1 Risk Aversion and Consumption Preferences The collective risk aversion of all investors is the most important factor of the MRP. When the collective risk aversion increases the MRP goes up, and down if the collective risk aversion decreases. Risk aversion between investors is different and the main factor that changes risk aversion is the age of the investor. The older an investor gets, the more his appetite for risk decreases, according to substantial evidence. That means that markets that have older investors will have higher MRP that a market with younger investors.

Consumption also has an impact on the MRP, assuming all other things remain equal. In markets where consumption is high the MRP is also high. But as consumption decreases and savings increase the MRP should also decrease (Damodaran A. 2., 2019). 24

3.1.2 Economic Risk The economic conditions within markets have an influence on the MRP. An economy where inflation, interest rate and economic growth are predictable factors should have a lower MRP than a market where these factors are more volatile (Damodaran A. 2., 2019). Connolly and Dubofsky found in their research that after the 2008 financial crises MRP increased for the US market as US treasury bond rates decreased. An inverse relationship between inflation and MRP was also found, with higher inflation leading to lower MRP (Connolly, Dubofsky, & Stivers, 2014).

3.1.3 Information The relationship between information and MRP is not simple. In theory a better stream of information to investors should lead to a decrease in the MRP, other factors remaining equal. A good stream of information should give a good indication on future earnings and cash flows. This stream of information can create more uncertainty if investors don’t agree on how to interpret the numbers.

Difference in the information stream between markets could be one of the factors why investors want higher risk premiums in emerging markets than in developed markets (Damodaran A. 2., 2019).

3.1.4 Liquidity and Fund Flows When it is easy for investors to sell their positions in equities markets are assumed to be liquid. However, if investors have to accept a substantial discount to liquidate their position in equities or pay high transaction fees a market is considered being illiquid. When markets are illiquid investors will pay less for equity investments and demand a higher MRP.

Another view on the liquidity problem is through fund flows. If there is an increase in fund flows into an equity market, could be from other asset classes or from other equity markets, for example foreign investment. With all other factors remaining equal, the MRP should decrease. Because fund flows create liquidity within the equity market. When it is the other way around, funds flowing out of an equity market, MRP should increase, assuming all other factors remaining equal (Damodaran A. 2., 2019).

3.1.5 Catastrophic Risk In equity investments, just like most other investments in life, there is always a chance of catastrophic risk, an event like the 2008 financial crises where there was a dramatic drop in wealth in both in Iceland and worldwide. Academics have studied the relationship between catastrophic risk and the MRP. The fact that catastrophic risk can happen unexpectedly translates into a higher MRP, with the risk of a negative return determining the MRP (Damodaran A. 2., 2019).

3.1.6 Government Policy A change in government policy can calm markets or stir them up. This can have an effect on the MRP. When there is uncertainty about government policy there can be a rise in the MRP (Damodaran A. 2., 2019).

3.1.7 Monetary Policy Central banks have tools that they can use to send signals to investors and companies about future growth and risk within their market. The MRP could rise if central bank moves the rates, he controls to zero and below (Damodaran A. 2., 2019).

3.1.8 The Behavioral/Irrational Component Investors are human, and humans don’t always behave rationally. This irrational behavior can have an impact on the MRP in two ways: • The Money Illusion: The inconsistency when investors mix together historical growth rates in earnings, which also includes past inflation, is used to forecast future earnings, which reflects past inflation, to forecast future earnings, but current interest rates, which include expectations of future inflation, to estimate discount rates. This can lead to a high MRP and an undervaluation of assets when inflation increases because the discount factor is wrong. • Narrow Framing: Investors can overestimate the risk their equity investments via narrow framing. That is when an investor is offered a new gamble, he evaluates that gamble in isolation, not including other risks that are in his portfolio, leading him to overestimate the risk of the gamble. That would cause a rise in the MRP (Damodaran A. 2., 2019).

3.2 Types of Market Risk Premiums Market risk premium can be estimated with various methods and can have various meaning to various individuals. Some view the MRP as the equilibrium long-term return while others see it as their own personal estimate of the long-term return. Some talk about it as a future return, while others talk about is as a realized return. Some compare equity returns with long-term returns on bonds or yields, while others compare short-term returns on bonds or yields (Ibbotson, 2011).

In the introduction three estimates for the MRP for the U.S. market where presented. They were all different, the difference comes from the fact that they represent different types of MRP. To gain a better understanding of the MRP it’s important to understand the different types of MRP.

In the field of finance and related textbooks there has been some confusion on the term MRP. The confusion comes from the fact the not all academics agree on how many types of MRP exist (Fernandez, 2017). MRP can be divided into four different categories: 1. Historical market risk premium. Historical differential return of the stock market over treasuries. 2. Expected market risk premium. Expected differential return of the stock market over treasuries. 3. Required market risk premium. Incremental return of a diversified portfolio (the market) over the risk-free rate required by an investor. It is used for calculating the required return to equity. 4. Implied market risk premium. The required equity premium that arises from assuming that the market price is correct (Fernandez, 2019).

Pablo Fernandez wrote a working paper where he evaluates definitions on the MRP in 150 textbooks. From the textbooks Fernandez reviewed, 129 of them claimed the required MRP being equal to the expected MRP. More so 82 of the 129 books also claim that the expected MRP equals the historical MRP. From those numbers one could conclude that approximately 55% of the 150 textbooks claim that there are only two types of MRP, historical and implied (Fernandez, 2017).

According to Fernandez the CAPM model assumes in cost of equity calculations that the required MRP and the expected MRP are unique but equal. That might be a simplification 27 because investors are not a homogeneous group that share the same expectations to market returns. Assuming that investors would have homogeneous expectations (sharing the same expected MRP), the required MRP would not be the same for all investors. If that was the scenario then the investors with lower required MRP would clear the market, because in their view the stock market would be undervalued. The implied MRP is the implicit required MRP when used in the valuation of a stock or an equity index that equals the market value with future cash flows to equity as an estimate (Fernandez, 2019).

3.3 Historical Market Risk Premium The most widely used method to estimate the MRP among investors and managers is the historical premium approach, where actual returns of the stock market over a long period are compared to the risk-free rate for the same time period (Damodaran A. 2., 2019). When using a historical MRP, a method that is built on past returns, a key assumption is made that is important to be aware of. The assumption is that the past is going to mirror the future, because the MRP is a forward-looking concept.

Historical MRP can be calculated using two formulas like Ibbotson and Goetzmann point out. The fist equation estimates net returns from investing in the stock market, relative to the return on bonds. The ratio of price relatives: 1 + �� (�) �� = − 1 1 + �� (�) Where: Rm (t) = the market return in year t Rf (t) = the risk-free return in year t

The second equation measures the net returns from investing in the stock market over long-term government bonds and is the most common definition of the MRP: �� = �� (�) − �� (�) Where: Rm (t) = the market return in year t Rf (t) = the risk-free return in year t The difference between the two equations is minimal (Goetzmann & Ibbotson, 2006).

When estimating past-returns of the market, a researcher must evaluate what is a good measurement of long-run past returns. The measurements have to reflect an implementable investment strategy. Equity indexes fit that criteria but what makes an

28 index a good or a bad one for estimating long-run returns? Dimson, Marsh and Staunton have listed five guiding principles that researchers should keep in mind when choosing an index: 1. The index should avoid look ahead bias and survivorship bias. 2. Long-term performance must be measured using total returns. 3. The index should represent the market and should ideally cover all industries. 4. Long-term return indexes need to use appropriate methods of weighting and averaging. 5. Assemble as broad a cross-section of countries as possible with indexes that fulfill the fourth principle when acquiring a global measurement (Dimson, Marsh, & Staunton, 2002).

Using historical data to estimate the MRP requires one to determine the time period of the historical returns. Some practitioners use all the data that is available, i.e. from the inception date. Others choose to use shorter time periods, e.g. 50, 20 or 10 years. The upside of using a shorter time period to estimate the MRP is that it reflects better the risk aversion of the average investor at a recent given point. The downside is however that statistically the standard error is higher when using less data, i.e. shorter time period. However, increasing the data set by using daily, monthly or quarterly returns does not have great effect on the standard error (Damodaran A. 2., 2019).

In literature there is a disagreement how to measure the historical returns like Brealey, Myers and Allen point out. Some calculate the historical returns against the returns on long-term government bonds. Other calculate the historical returns against the yield on long-term government bonds. Others calculate the difference between compound rate of return on stocks and the interest rate (Brealey , Myers, & Allen, 2017). Koller, Goedhart and Wessels argue that yields on government bond better reflect market prices and should therefore be used to estimate the risk-free rate and the cost of equity (Koller, Goedhart, & Wessels, 2015).

After determining the time period to study the historical returns and the methodology, the practitioner faces two other factors that can have effect on the historical MRP. One is the choice of government bond to represent the risk-free rate and the other is the averaging method for the time period. Discussion about the risk-free rate took place in chapter 2.5.

How is all the data is converted into an annual number? That is done with either an arithmetic average or a geometric average of the whole data set. These two averaging methods will not give the same result.

An arithmetic average, simple average, sums up the premium for each year and divides it with the number of observations (Koller, Goedhart, & Wessels, 2015): 1 1 + �� (�) ��ℎ�� = ∑ − 1 � 1 + �� (�) Where: T = number of observations Rm (t) = the market return in year t Rf (t) = the risk-free rate in year t

A geometric average compound each year’s excess return and takes the root of the resulting result (Koller, Goedhart, & Wessels, 2015): 1 + �� (�) �� = ∏ − 1 1 + �� (�) Where: T = number of observations Rm (t) = the market return in year t Rf (t) = the risk-free rate in year t

Which averaging method should be used to estimate the MRP? The most used method to statistically measure the unbiased estimator of the mean for one period is the arithmetic average. When valuating companies with many years of cash flow a one period estimator is not sufficient. A compounded rate of return is required to estimate such cash flows. When arithmetic average is taken on compounded returns it will generate an upward biased MRP. The bias comes from technical statistical factors such as estimation error that can lead multi period measurements to be too high (Koller, Goedhart, & Wessels, 2015). Investors usually use the geometric average of market returns minus long-term government bond return (Ibbotson, 2011). There are two strong arguments for using a geometric average. The first one is that although the cost of equity models reviewed in the previous chapter are all single period models, they are used to get expected returns over long periods, e.g. 5 or 10 years, indicating that the estimation period has to be much longer than one year. The second point is that according to Fama and French the returns on the stock market are negatively correlated (Fama & French, 1992), using arithmetic 30 average will overestimate the returns. These points make arguments for using geometric average stronger. Using arithmetic average will always generate a higher MRP than when a geometric average is used. In both corporate finance as well as in valuation arguments for using the geometric average are strong (Damodaran A. 2., 2019).

There is however a middle ground between the two averaging methods. A horizon- weighted average of the arithmetic and geometric averages formula proposed by Marshall Blume to correct for estimation error and autocorrelation of returns (Blume, 1974):

� = �� + �� Where: T = Number of historical observations in the sample N = Forecast period being discounted RA = Arithmetic average of the historical sample RG = Geometric average of the historical sample In a study conducted by Indro and Lee a comparison between arithmetic and geometric premiums is conducted, they find them both biased of long run estimates. The bias increases with the length of the investment horizon. They also concluded that the horizontal weighted average contains the least bias expected returns (Indro & Lee, 1997). When estimating the historical MRP, it is important to keep the influence in mind that the survivorship bias has on the excess returns in markets. Survivorship in context of indexes can happen when the back-history of the index is influenced by the absence of companies that underperformed and became non-existed when the index was introduced (Dimson, Marsh, & Staunton, 2002).

When estimating the historical MRP transparency is very important. The time-period, proxy for the risk-free rate and averaging method have a lot to say about the final outcome of the calculation.

3.3.1 Studies on the Historical Market Risk Premium Elroy Dimson, Paul Marsh and Mike Staunton are the authors of the book Triumph of the Optimists, 101 Years of Global Investment Returns which was released 2002. It contains historical MRP for 16 countries from 1900. Since 2002 Dimson, Marsh and Staunton have published an updated global estimate of the historical MRP for 19 countries in their chapter Equity Premiums around the World. Below is a table with the historical MRP for the 19 countries from 1900-2010, relative to long-term government bonds. Also including

an MRP estimate for Europe, the world and the world excluding the US. Market (Dimson, Marsh, & Staunton, 2011). Dimson, Marsh and Staunton update their database annually and publish their results in Credit Suisse Global Investment Returns Yearbook. In the right section of the table are the numbers from the 2018 issue to compare the difference between the time periods (Dimson, Marsh, & Staunton, 2018). Table 1. Historical Market Risk Premiums for two time periods, 1900-2010 and 1900-2017.

Market risk premiums Relative to Market risk premiums Relative to Bonds, Bonds, 1900-2010. 1900-2017. Geometric Arithmetic Standard Geometric Arithmetic Standard Country mean mean error mean mean error Australia 5.9% 7.9% 1.9% 5.0% 6.6% 1.7% Belgium 2.6% 4.9% 2.0% 2.2% 4.3% 1.9% Canada 3.7% 5.3% 1.7% 3.5% 5.1% 1.7% Denmark 2.0% 3.4% 1.6% 2.2% 3.8% 1.7% Finland 5.6% 9.2% 2.9% 5.2% 8.7% 2.7% France 3.2% 5.6% 2.2% 3.1% 5.4% 2.1% Germany 5.4% 8.8% 2.7% 5.1% 8.4% 2.6% Ireland 2.9% 4.9% 1.9% 2.7% 4.7% 1.8% Italy 3.7% 7.2% 2.8% 3.2% 6.5% 2.7% Japan 5.0% 9.1% 3.1% 5.1% 9.1% 3.0% The Netherlands 3.5% 5.8% 2.1% 3.3% 5.6% 2.0% New Zealand 3.8% 5.4% 1.7% 4.0% 5.6% 1.6% Norway 2.5% 5.5% 2.7% 2.4% 5.4% 2.5% South Africa 5.5% 7.2% 1.9% 5.3% 7.1% 1.8% Spain 2.3% 4.3% 2.0% 1.8% 3.8% 1.9% Sweden 3.8% 6.1% 2.1% 3.1% 5.3% 2.0% Switzerland 2.1% 3.6% 1.7% 2.2% 3.7% 1.6% United Kingdom 3.9% 5.2% 1.6% 3.7% 5.0% 1.6% United States 4.4% 6.4% 1.9% 4.4% 6.5% 1.9% Europe 3.9% 5.2% 1.6% 3.0% 4.3% 1.4% World ex- USA 3.8% 5.0% 1.5% 2.8% 3.8% 1.3% World 3.8% 5.0% 1.5% 3.2% 4.4% 1.4% Source: Historical MRP 1900-2010 (Dimson, Marsh, & Staunton, Equity Premiums around the World, 2011). Historical MRP 1900-2017 (Dimson, Marsh, & Staunton, Credit Suisse Global Investment Returns Yearbook 2018, 2018) The average standard error for the world goes down from 1.5% to 1.4% by adding 7 years to the time period. The most interesting point though, is the decline in the MRP for the world economy, going from 3.8% to 3.2% and even lower if the U.S. market is excluded, 2.8%. 32

Roelof Salomons and Henk Grootveld studied and compared MRP in emerging markets versus developed markets. They found that MRP in emerging markets are significantly higher than in developed markets. In their research Salomons and Grootveld estimated the average monthly MRP along with the standard deviation. From that data it is possible to estimate the annual arithmetic average MRP as well as the standard error. The time period for the MRP is from 1976 – 2002. Except for the two countries China (begins in November 1993*) and South Africa (begins in January 1994**) (Salomons & Grootveld, 2002).

Table 2. Historical Market Risk Premium from 1976-2002.

Country Market risk premium Standard error Canada 1.69% 3.89% China 8.34% 16.81%* France 4.91% 4.48% Germany 3.41% 4.08% India 4.16% 5.51% Italy 3.91% 5.19% Japan 3.91% 4.54% South Africa -4.12% 10.24%** United Kingdom 4.41% 3.93% United States 3.66% 2.96% Source: (Salomons & Grootveld, 2002).

When comparing the two researches of Dimson, Marsh and Staunton to Salomons and Grootveld’s it is clear that using longer time periods when estimating the MRP leads to a lower standard error. China and South Africa have extremely high standard error because the estimation period is roughly 8 years for both countries. Damodaran argues that the magnitude of the standard error in Salomons and Grootveld’s research makes the data close to useless (Damodaran A. 2., 2019).

The Icelandic stock market doesn’t have the same historical magnitude as these 19 countries, with the birth of the market taking place in 1993. The historical MRP has been estimated for the OMXIPI index for the time period 1998 – 2017 resulting in a geometric average of -10.1% and an arithmetic average of 4.6% (Sigurðsson, 2019).

3.4 Implied Market Risk Premium Historical MRP look backwards when estimating the future excess returns of the market. Implied MRP is a forward-looking approach where current share prices and corporate performances are used to solve for the expected rate of return. When assets such as stocks and indexes are priced market participants are also stating what is the required rate of return for that asset. Aswath Damodaran believes that equity markets have changed after the 2008 financial crises in a way that the MRP is no longer a fixed number. Instead the market risk premium is more floating and can change quickly both in mature and other markets. Because of this new reality using a MRP that is different from the implied MRP will in valuation practices add a market view into the individual company valuation (Damodaran A. 2., 2019).

Duff and Phelps seem to share this view up to certain extent, they look at three different models for estimation of the implied MRP and use them to validate their own estimate of the MRP. The three models are the following: - Damodaran Implied MRP Model - Default Spread Model - Risk Premium Factor Implied MRP (Duff & Phelps, 2016).

3.4.1 Determinants of Implied Market Risk Premium Before taking a closer look into the three different methods Duff and Phelps use, a brief overview on the four determinants of the implied premiums according to Aswath Damodaran will be conducted to gain a better understanding of implied premiums. 1. Implied market risk premium and Interest rates: Does the risk-free rate affect the MRP? Would the MRP stay the same if yields on long term government bonds increased significantly, e.g. from 4% to 10%? To answer those questions Damodaran regressed the implied MRP against the treasury bond rate and the slope of the yield curve from 1960 - 2018. His results point to the direction of a positive relationship between implied premium and treasury bonds, although the t-statistics are not significant. After the financial crises in 2008 the positive trend between the MRP and treasury bonds has gone into reverse with declining treasury bond yields at the same time as the MRP has increased (Damodaran A. 2., 2019).

2. Implied market risk premium and Macroeconomic variables: To expand on the relationship between the MRP and interest rates other macroeconomic variables can be included, such as economic growth, inflation rates and exchange rates. Damodaran calculated the correlation between those variables against the implied MRP of the S&P500 using data from 1973-2018. His results are that the MRP is negatively correlated with GDP growth and positively correlated with inflation (Damodaran A. 2., 2019). 3. Implied market risk premium Earnings Yields and Dividend Yields: If assumptions are made about future growth or expected excess returns, earning yields and dividend yields can be used as proxies for the MRP. Damodaran studied the movement of earning yields and dividend yield against the MRP. His results are that dividend yields where a good proxy for the MRP until the introduction of stock buybacks in the 1980s. To use earning yields as a proxy for the MRP it is important to minus out the risk-free rate, when doing so it can yield negative numbers. But data shows that the earning yields do move with the MRP (Damodaran A. 2., 2019). 4. Implied market risk premium and Technical Indicators: Technical indicators such as, moving averages and momentum measures are used by many market timers to predict in what way the market is moving. These movements can also predict in what direction the implied MRP is heading (Damodaran A. 2., 2019). In a research on the efficacy of technical indicators by Neely, Rapach, Tu and Zhou concluded that a composite prediction, that uses both macroeconomic and technical indicators, is better than using just one of those variables (Neely, Rapach, Tu, & Zhou, 2011).

3.4.2 Implied Market Risk Premium Models There are number of methods available to calculate the implied MRP. The models can focus on different determinants of implied MRP. To shed a light on the difference between the models an introduction into the three models that Duff and Phelps use to validate their own estimate of the MRP will be conducted. These three models all rely on different determinants of the implied MRP.

Discounted Cash Flow Model-Based Premium Damodaran has from 2008 onwards issued a yearly update on his working paper Equity Risk Premiums (ERP): Determinants, Estimation and Implications (frequently cited in this and previous chapters). Damodaran puts the most weight in his coverage of implied MRPs in discounted cash flow model-based premium. Like stated in the beginning of the chapter stock prices include the expected return on that specific stock. Assuming that dividends are a growing perpetuity, the Gordon growth model can be used: �� = (�� − �� ℎ ��) We do so by expanding the Gordon growth model to the whole market with a market index. It’s fairly simple to solve for the required rate on equity for the whole market, if all other factors are known. Using the CAPM model, the beta for the market is 1, it is only the matter of deducting the risk-free rate from the required return on equity to find the MRP.

Damodaran has implemented discounted cash flow model on the S&P500 index. A two- stage valuation model using the same growth forecast for the first five years and then a perpetuity growth for the sixth year. The perpetuity growth rate equals the risk-free rate. Damodaran also adds buyback yield to the dividend yield to estimate total cash to investors. The reason is that stock buybacks have become a generally accepted way of returning cash to investors and preferred over dividends by some companies. The formula is the following: � ∗ � � ∗ � � ∗ � � ∗ � � ∗ � (� ∗ �) ∗ (1 + ��) �� = + + + + + (1 + �) (1 + �) (1 + �) (1 + �) (1 + �) (� − ��)(1 + �) Where: C = Cash to investors g = Earnings growth gf = Future growth rate r = Required return on equity rf = Risk-free rate

Cash to investors is estimated using the trailing 12-month data on dividend and buyback yields of the S&P500 constituents. Earnings growth is retrieved via top down analysis and the risk-free rate is the treasury bond rate.

Studies using Discounted Cash Flow Model-Based Premium Damodaran has implemented this formula on the S&P500 index from 2010 with good results. The average implied MRP for the time period 2010-2019 is 5.28%. Below in the table are Damodaran results for each year from 2010 (Damodaran A. 2., 2019).

Table 3. Damodaran Implied Market Risk Premium for the S&P500 index from 2010-20193

Implied market risk Year premium 2010 4.36% 2011 5.20% 2012 6.01% 2013 5.78% 2014 4.96% 2015 5.78% 2016 5.16% 2017 4.50% 2018 5.08% 2019 5.96% Source: (Damodaran A. 2., 2019).

The Fenebris Expert Circle consisting of Prof. Dr. Christoph Kaserer, Prof. Dr. Tobias Berg, Dr. Timo Willerhausen and CFA Daniel Kittlauss publish on their website implied MRPs for number of countries, using a four-stage dividend discount method. In their model the current market value, 1,2- and 3-year dividend forecasts and long-term growth are used to estimate the implied MRP. By using data provided on their website and taking a ten-year geometric average from 2010-2019 an implied MRP for each country was estimated (Kaserer, Willershausen, Berg, & Kittlauss, 2019).

Table 4.Fenebris Implied Market Risk Premium for 19 countries using geometric average for the time period 2010- 2019.

Implied market Country risk premium Australia 4.61% Belgium 6.55% Canada 5.48% China 5.50% Denmark 5.16% Finland 6.04%

3 Data gathered from (Damodaran A. 2., 2019). 37

France 6.57% Germany 6.81% India 2.60% Italy 7.48% Japan 6.76% Norway 6.14% South Africa 3.48% Spain 7.08% Sweden 5.54% Switzerland 6.31% The Netherlands 6.53% United Kingdom 5.64% United States 4.59% Europe 6.32% World 5.73% Source: (Kaserer, Willershausen, Berg, & Kittlauss, 2019). When comparing the Fenebris implied MRP for the United States, 4.59%, against the implied premium from Damodaran, 5.28%, a clear difference comes to surface. The difference can be from the fact that Damodaran adds buybacks to dividend yield to estimate cash to investors, Fenebris only uses dividend yields. Another factor that can also have an effect is the length of the discount model, 4-stage model against 6-stage model. Growth expectations also have an effect, more on that later in this chapter. There has been a study on the implied MRP in Iceland using a slightly different version of the dividend discount formula presented above. The P/E ratio is used in a two-stage valuation formula also containing trailing twelve-month dividend payout ratio, future dividend payout ratio, next year’s profit growth and long-term profit growth.

∗() ∗()() = + ∗ () () () Where: Div TTM = Trailing Twelve-Month Dividend Payout Ratio Div f = Future dividend payout ratio g = Next year forcasted profit growth gf = Future profit growth r = Cost of equity

Using the P/E ratio for the OMXI6/8/15 index, the average implied MRP for the time period 1998-2017 was 4,3%, using the time period 2010-2017 an average of 5,6% was the result (Sigurðsson, 2019).

Default Spread Model The default spread model is at its essence the relationship between risk premiums between different asset classes, e.g. corporate bonds, stocks and real estate. The average long-term MRP is assumed to be a constant and spreads from that average over an economic cycle can be measured by the spreads from the long-term average of the default spread (Baa- Aaa) (Duff & Phelps, 2016).

Of all the methods available to estimate the implied MRP the default spread model is the one that is the simplest to implement and estimate from, with all the data necessary for the model very accessible. Assume a spread between a Bba rated corporate bond and a Aaa rated government bond being 3%. Then ‘double’ that spread to estimate the MRP of then 6%. Damodaran researched if this approach could be used to validate other estimations of the implied MRP. His conclusion is that there is too much noise to develop a reliable rule of thumb, whether the spread should be doubled or not. But there is enough relationship to use it to validate other estimates (Damodaran A. 2., 2019).

Note that Iceland’s current Moody’s credit rating is A-3, after the financial crises of 2008 Iceland was downgraded from a Aaa credit rating down to Baa3 rating (The Central Bank of Iceland , 2019).

Studies on the Default Spread Model Jerome S. Fons found in his research of using default rates to model the term structure of credit risk, that smaller, younger and more leveraged companies tend to have a bigger credit spread than mature and stable firms (Fons, 1994).

Elton, Gruber, Agrawal and Mann concluded in their research, explaining the rate spread on corporate bonds. That the spread between corporate and government bonds comes largely from two main factors, difference in taxation being one factor. The other factor is the risk premium. The research shows that the spread is correlated with priced systematic risk factors that affect bond and stock prices. Also, the difference in spread between companies is related to their different sensitivity to systematic factors (Elton, Gruber, Agrawal, & Mann, 2001).

In the table below a clear correlation is visible between the implied MRP and Baa default spread. When the default spread increases the implied MRP follows, the same happens 39 when the spread decreases. The correlation stops in 2018 when the default spread decreases but the implied MRP increases (Damodaran A. 3., 2019).

Figure 1. U.S. Default Spread vs. S&P500 Implied- and Historical Market Risk Premiums from 2010-2018

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00% 2010 2011 2012 2013 2014 2015 2016 2017 2018

Source: Data retrived from a excel speadsheet (Damodaran A. 3., 2019)

Country Risk Premiums Lally and Randal concluded in their research, estimating the MRP using data from multiple markets, which regardless of the methodology used to estimate the MRP, data from multiple markets provides a better estimate of the MRP than using only domestic data (Lally & Randal, 2015).

Expanding on the default spread model, a country risk premium can be estimated for an equity market based on its country credit rating. The rating-based default spread is estimated by finding the premium a country has to pay based on its credit rating from a AAA rating. The rating-based default spread is then multiplied with an additional volatility factor of emerging equity markets, currently 1.23, to find the country risk premium (Damodaran A. 1., 2019).

After estimating the country risk premium, the MRP can be calculated using the following equation: �� = �� + ��

In the table below are MRP calculations from Damodaran, he uses his 2019 implied MRP for the S&P500, 5.96%, as a base premium for a mature equity market. Table 5. Country Risk Premium-based Market Risk Premium for 2019

Rating-based Market Risk Country Risk Country Moody's rating Default Spread Premium Premium Australia Aaa 0.00% 5.96% 0.00% Belgium Aa3 0.68% 6.80% 0.84% Canada Aaa 0.00% 5.96% 0.00% China A1 0.79% 6.94% 0.98% Denmark Aaa 0.00% 5.96% 0.00% Finland Aa1 0.45% 6.51% 0.55% France Aa2 0.56% 6.65% 0.69% Germany Aaa 0.00% 5.96% 0.00% Iceland A3 1.35% 7.63% 1.67% India Baa2 2.15% 8.60% 2.64% Italy Baa3 2.48% 9.02% 3.06% Japan A1 0.79% 6.94% 0.98% Netherlands Aaa 0.00% 5.96% 0.00% South Africa Baa3 2.48% 9.02% 3.06% Spain Baa1 1.80% 8.18% 2.22% Sweden Aaa 0.00% 5.96% 0.00% Switzerland Aaa 0.00% 5.96% 0.00% United Kingdom Aa2 0.56% 6.65% 0.69% United States Aaa 0.00% 5.96% 0.00% Source: (Damodaran A. 1., 2019).

By using this approach Iceland has a MRP of 7.63% (Damodaran A. 1., 2019).

Comparing this MRP to the Fenebris implied MRP gives an average difference of 1.12%. The reason why the country risk based MRP is higher on average could be from the fact that the base premium used, 5.96%, is relatively high compared to the historical MRPs in table 1.

The economic department of Landsbanki views that when using country risk premiums in MRP estimates practitioner has to realize that there is a possibility that the default spread is included twice in the cost of equity calculation with the domestic risk-free rate also including the rating based default spread (Hagfræðideild Landsbankans, 2016).

Risk Premium Factor Implied Market Risk Premium Model Stephen Hassett’s Risk Premium Factor (RPF) valuation model is designed to explain levels and changes in market value to identify periods of likely mispricing. The model uses generally accepted approach to valuation, with the estimation of the MRP the most innovated part of the model. The estimation of the MRP produces a very good explanation of the P/E ratio and overall market levels.

Hassett argues that the MRP is not a fixed number but a variable that moves with the long-term risk-free rate as a fixed percentage, not as a fixed premium. One of Hassett arguments is the same as the first question asked in the determinants of implied MRP. Will investors be satisfied with a constant risk premium when the risk-free rate changes, investors receiving a premium that could be a smaller portion of the risk-free rate.

On that thought the formula for the MRP is: �� = �� ∗ �� This relationship is assumed to be the reason why the MRP changes over time.

Like many other valuation models Hassett’s model also builds on the Discounted Cash Flow (DCF) model. The model assumes a perpetual stream of cash flow with a constant rate of growth. The discounted cash flow model can be expressed as: � � � � = + + ⋯ + (1 + �) (1 + �) (1 + �) Where: P = Price E = Earnings C = Cost of equity

The simplified version of the DCF formula, where growth is assumed to be constant would be: � � = (� − �) Where: P = Price E = Earnings C = Cost of equity G = Expected long term growth rate 42

This formula can then be altered to predict the P/E ratio of a company or an index: = () This P/E equation, when using the right assumptions is the foundation of Hassett’s model to explain levels and changes in the market value.

There is a disagreement between academics and practitioners if equity should be valued based on earnings or dividends. Hassett argues that expected future profits provide just as good of a reflection of the company capital structure and investment opportunity as the dividend policy (Hassett, 2010). Modigliani and Miller concluded in their research on Dividend Policy, Growth, and the Valuation of Shares that the dividend policy was irrelevant as determinant of corporate market values (Modigliani & Miller, 1961). Hassett also adds that most growth companies pay little or no dividends, making earnings a better estimator of future profitability than dividends.

The P/E ratio is often used as a proxy to determine if share prices are cheap or expensive. Ásgeir Jónsson and Stefán B. Gunnlaugsson examined the relationship between P/E ratio, q-ratio, dividend yield, historical returns, company size and returns on Icelandic stocks using data from 1993-2003. Their results are that returns on stocks with low P/E ratio are higher than returns on other stocks. Also, the returns of small stocks and stocks with low q-ratio are higher than other stocks, the difference not being statistically significant. They also found no relationship between historical returns and future returns, and between returns and dividend yield (Jónsson & Gunnlaugsson, 2004). When the P/E ratio is used in context with constant growth it is important to be conscious about the fact that minimal changes in growth can have a big influence on the price.

The Capital Asset Pricing model, previously introduced in chapter 2.6, is used to estimate the required return on equity. With the beta of the whole market equal to 1, the formula for cost of equity can be simplified to: �� = �� + ��

The main difference between Hassett’s cost of equity and the conventional CAPM model is the formula for the MRP. With the formula for the MRP being the multiple of the risk- free rate and the risk premium factor, the cost of equity for the market can be presented as: �� = �� ∗ (1 + �� ) 43

The P/E ratio including the risk premium factor is the following equation: = (∗()) Where: P = Price E = Actual annualized Earnings Rf = Risk-free rate RPF = Risk premium factor G = The expected nominal long-term growth rate, broken down to real growth + inflation, (1+g) * (1+i) - 1.

The risk premium factor is a variable that does not change often for the U.S. market. For the last 50 years it has only changed two times, in 1981 and 2002 according to Hassett. The risk premium factor is derived using linear regression in order to find the best fit over long periods. Hassett isolates interest rates as the independent variable in the following equation: � �� ∗ (1 + ��) = + � � The regression analysis is then conducted using the risk premium factor as the independent variable. These factors are then applied to the final model and the full data set to find the best factor. Hassett then fits the model to actual S&P levels to estimate RPF, using R-squared as a measurement to find the appropriate RPF for each time period. By estimating the risk premium factor Hassett is able to estimate what the MRP is, from the current yield on government bonds.

There are however some potential weaknesses in the risk premium factor theory and methodology that Hassett points out: - All data points are current, actual or historical. The model is based on actual historical data with the market forward looking, with all the data needed to estimate the risk premium factor collected at a single point in time. - Reason for change in the Risk Premium Factor are not fully explained. Hassett has not been able to fully explain the changes on the RPF over time and recommends further research on that topic. - The Risk Premium Factor may seem to be set arbitrarily to fit actual data. With a linear regression that aims to fit a single number across numeral data points the RPF doesn’t eliminate this concern. 44

- Risk Premium Factor cannot be projected. To estimate the risk premium factor the practitioner needs to rely on historical data, although the factor has not changed often – it is unclear when it’s going to change (Hassett, 2011).

The Risk Premium Model can also be used to estimate implied values of all the variables used in the model by rearranging the equation. The risk premium factor can be calculated with the following equation: � + � − �� = � �� This equation has its limits, it can only estimate the MRP when earnings are positive. When earnings become negative the MRP also becomes negative, and that does not make any sense. Because with increased risk in the equity market investors would want a bigger premium and not a negative one. The S&P500 index has never produced negative earnings, but that has happened with Icelandic indexes (Hassett, 2011).

Fernando Duarte and Carlo Rosa did a staff report for the Federal Reserve Bank of New York where they compare 20 different methods to estimate the MRP. They concluded that a bond driven estimate of the MRP provides the best estimate for the MRP (Duarte & Rosa, 2015). In the figure below the MRP from 1990-2009 is presented, along with the risk-free rate and the risk premium factor for the same time period.

Figure 2. Implied Market Risk Premium for S&P500 using the Risk Premium Factor from 1990-2009. 4

Risk Free Rate (Rf) 10 Yr Treasuy Yield Risk Premium Factor Market Risk Premium

9.000

8.000

7.000

6.000

5.000

4.000

3.000

2.000

1.000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: (Hassett, Hassett/The Risk Premium Factor, 2019). The risk-free rate and the MRP are presented as whole numbers to accommodate the risk premium factor in the figure. The average MRP for S&P500 for the time period 1990- 2009 is 5.73% (Hassett, 2019). In an article on Seeking Alpha, Steve Hassett states that the risk premium factor still is 1.48 (Hassett, 2019). Hassett confirmed that in an email conversation, also providing the author with an updated estimate of the MRP relative to a 10-year treasury yield. In the figure 3 provides us with a more recent estimate of the MRP using the time period 2010 – 2019 (personal communication, August 9, 2019).

4 Data retrieved via excel spread sheet (Hassett, 2019) 46

Figure 3. Implied Market Risk Premium for S&P500 using the Risk Premium Factor from 2010-2019

Risk Free Rate Risk Premium Factor Market Risk Premium

6.000

5.000

4.000

3.000

2.000

1.000

- Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19 Source: Data retrived via excel spread sheet via email Stephen D. Hassett (personal communication, August 9, 2019). The average MRP has decreased during the time period 2010-2019 down to 3.55%. The reason why there is a decline is because U.S. interest rates have been declining also for the same time period with the risk premium factor unchanged.

3.4.3 The Relationship Between Implied Market Risk Premium and Growth Expectations After going over both Damodaran and Hassett approaches to estimate the implied MRP it is clear that growth expectations play a big role in Gordon´s growth model. Different growth expectations will yield different implied MRP. Do investors have a homogeneous view of growth expectations of the market and consequently share the same required or implied MRP? According to a study conducted by Doukas, Kim and Pantzalis on divergence of opinion and equity returns they find that investors do not share the same growth expectations. They found a significant relationship between future returns on the stock market and divergence of opinions among investors (Doukas, Kim, & Pantzalis, 2006).

If all investors shared the same growth expectation, then they would share the same unique implied MRP. The reality is that there are as many implied MRPs as there are different expectations of growth. An investor that is expecting higher growth will have a higher implied MRP (Fernandez, 2019). 47

3.5 Survey on the Expected and Required Market Risk Premium The expected MRP is, like the name suggests, investors’ expectations on the return they will get in their equity investments over the risk-free rate. Since investors are not a homogenous group in terms of expectations to the market, there is not a single expected MRP, just like there isn’t a single required MRP. The required MRP is the incremental return investors demand over the risk-free rate. Historical MRP is not a good proxy of the expected MRP because of the survivorship bias that gives an optimistic view of the premium. Another reason why the historical MRP isn’t a good proxy is the fact that there is no guarantee that the future is going to mirror the past (Fernandez, 2019).

3.5.1 Studies on the Expected and Required Market Risk Premium The required MRP has previously been described, in chapter 3.2, as the “Incremental return of a diversified portfolio (the market) over the risk-free rate required by an investor. It is used for calculating the required return to equity.” Both the expected and required MRPs can be found via surveys. Fernandez surveys annually finance and economics professors, analysts and managers of companies about the risk-free rate (RF) and market risk premium (MRP) that they use in their required return to equity calculations for different countries. The participation for the 2019 survey was 1.836 replies from more than 20.000 emails that the survey was sent to (Fernandez, Martinez, & Acín, 2019). In the table on the next page are the average risk-free rates and required MRPs for the 19 countries that have been previously used in the historical, and implied MRP chapters.

Table 6. Required Market Risk Premium around the world via survey, 2019, -18, -17 and -15

Average 2019 Average 2018 Average 2017 Average 2015 Country RF MRP RF MRP RF MRP RF MRP Australia 2.8% 6.5% 3.1% 6.6% 3.0% 7.3% 3.1% 6.0% Belgium 1.2% 6.2% 1.6% 6.2% 1.7% 6.4% 1.3% 5.5% Canada 2.5% 5.8% 2.9% 5.8% 3.0% 6.0% 2.3% 5.9% Denmark 1.2% 6.0% 1.6% 6.0% 1.6% 6.1% 1.3% 5.5% Finland 1.1% 6.2% 1.7% 5.9% 1.7% 5.9% 1.2% 5.7% France 1.2% 6.0% 1.6% 5.9% 1.8% 6.5% 1.5% 5.6% Germany 1.1% 5.7% 1.4% 5.3% 1.4% 5.7% 1.3% 5.3% Ireland 1.4% 6.0% 1.6% 6.5% 1.7% 6.7% 1.3% 5.5% Italy 1.6% 6.3% 2.3% 6.1% 2.6% 6.4% 1.5% 5.4% Japan 1.1% 6.1% 0.3% 5.7% 0.3% 6.0% 0.7% 5.8% The Netherlands 1.3% 6.0% 1.7% 5.8% 1.7% 6.0% 1.8% 5.9% New Zealand 3.0% 5.9% 3.1% 5.8% 2.9% 5.6% 2.9% 6.6% Norway 1.4% 6.0% 2.4% 5.7% 2.3% 6.1% 1.4% 5.5% South Africa 8.0% 8.4% 7.6% 6.9% 7.5% 7.5% 8.2% 7.7% Spain 1.7% 6.4% 2.1% 6.7% 2.2% 6.6% 2.2% 5.9% Sweden 1.3% 6.1% 1.8% 7.1% 1.7% 6.8% 1.1% 5.4% Switzerland 1.1% 6.2% 1.1% 6.9% 1.3% 7.1% 1.1% 5.4% United Kingdom 2.1% 6.2% 2.0% 5.5% 2.2% 5.9% 2.1% 5.2% United States 2.7% 5.6% 2.8% 5.4% 2.5% 5.7% 2.4% 5.5% Source: (Fernandez, Martinez, & Acín, 2019). When it comes to surveys on the expected MRP John R. Graham and Campbell R. Harvey analyze the expected MRP between U.S. Chief Financial Officers (CFOs) quarterly from June 2000. They ask the managers what they expect the 10-year S&P 500 return relative to a 10-year U.S. Treasury bond yield to be in the coming quarter. In their latest publication, CFO´s where asked in December 2017, the average expected MRP was 4,42%. That is considerably higher than the average expected MRP for the entire survey period which is 3,63% (Graham & Harvey, 2018).

Antti Ilmanen concluded in his study on the expected returns on stocks and bonds, that surveys can lead to higher MRPs because of the optimism of participants. Surveys show the “hoped for” returns rather than the required returns, with participants expecting the market to produce high returns that translates into a higher MRP (Ilmanen, 2003).

In Iceland, Arion Bank conducted a survey every 6 months from 2013 to 2017 asking investors what annual return they expected to receive from the OMXI6/8 equity index as

49 well as what MRP they used for the Icelandic market. The reason why the survey stopped in 2017 is because the participation was not good enough among investors for the bank to draw significant conclusions from the survey. In their last survey in June 2017 the average MRP was 5.4% and the median was 4.5%5 (Elvar Ingi Möller, personal communication June 3, 2019).

3.7 The Equity Premium Puzzle In 1985 Mehra and Prescott asked the financial world a tough question: The historical MRP is larger than can be explained with standard neoclassical paradigm of financial economics. This has since been referred to as the equity premium puzzle (Mehra & Prescott, 1985). This puzzle has since been a subject for financial academics to explain why the historical MRP when compared to risk-aversion coefficients leads to investors having an extremely high-risk aversion.

Damodaran list out 5 reasons for why there is such a difference between those approaches: 1. Statistical artifact: The historical MRP is biased upwards because of survivorship bias. 2. Disaster Insurance: The observed volatility in equity markets does not account for uncommon disastrous events that have negative effect on wealth and consumption. 3. Taxes: A decline in marginal tax rate can drive up equity prices. The decline in reality has not been of the magnitude to explain the rise in the MRP. 4. Alternative Preference Structures: Returns on stocks and consumption are correlated, when consumption decreases, e.g. in recession, stock returns decrease as well. The additional risk explains the higher observed MRP. 5. Myopic Loss Aversion: Increased monitoring of investments leads investors to experience more risk in equity investments according to behavioral finance. With more frequent monitoring the MRP increases (Damodaran A. 2., 2019). The equity premium puzzle has not been solved but Mehra, one of the authors of the original paper, believes that there has been a great progress made and the equity premium is not as big of a puzzle as it was. Mehra concludes that the equity premium is not a premium for bearing non-diversifiable risk (Mehra, 2006).

5 Information retrived via email from the Research Department of Arion Bank 50

4. Research After reviewing the methods that are used to estimate the cost of equity and the market conditions that are required to use them to calculate the cost of equity, it could be pointed out that these methods don’t apply to the Icelandic market because of its inefficiency. Because the models that use MRP to estimate cost of equity don’t hold up for the Icelandic market and consequently because of the inefficiency of the market it is pointless to research the MRP in Iceland. Evidence from both market practitioners and in government regulations point to the contrary, as the CAPM-model seems to be the most used model to estimate the cost of capital and the MRP plays a big role in CAPM calculations.

Landsbankinn uses CAPM in all of their valuation models to estimate cost of equity and then calculate the weighted average cost of capital to discount future cash flows (Hagfræðideild Landsbankans, 2016). Ministry of Industries and Innovation6 has released a regulation number 192/2016 where CAPM is used to estimate cost of equity for the WACC formula to determine the weighted cost of capital as a benchmark for permitted return on investment determining the income limits of the concession companies in the transmission and distribution of electricity sector, in the regulation MRP is determined to be 5%.

The research methods to estimate the MRP varies between the different types of MRP. In this chapter an in-depth analysis on the estimation approaches is going to be conducted for the different types of MRP, the historical premium, implied premium and the required or expected premium. There is also going to be a coverage on the time period for the research and the risk-free rate used for each period.

4.1 Time Period The time period for this research is from 2010 to 1st quarter of 2019. There are three reasons why this time period is preferred: The first reason is the bubble phase period covered in chapter 3.6 that ended with the financial crises in 2008 distorts historical analysis like Benedikt Sigurðsson encountered in his research on the MRP. The second reason is that this time period has not been studied specifically by academics and therefore provides a contribution to other literature written on the field of finance. The third reason

6 Atvinnuvega- og nýsköpunarráðuneytið 51 is that the time period, 2010-2019, gives a good indication on the risk aversion of the average investor post the financial crises, with reference to chapter 3.3 where Damodaran suggests that the biggest advantage of using shorter time periods is the reflection it gives on the risk aversion of the average investor.

Figure 4. Annual returns on OMXIGI, OMXIPI and OMXI8GI equity indexes from 2010-2019.

OMXIGI OMXIPI OMXI8GI

50.00%

40.00%

30.00%

20.00%

10.00%

0.00% 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

-10.00%

Source: Data retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

Like the graph shows the annual returns on equity indexes over the research period are far from being linear, with both positive and negative returns. There are indicators that the time period from 2010 to today is close to become an economic cycle with the economy cooling down in Iceland with key interest rate of the central bank at 3.5%.

After the financial crises of 2008 a rapid decline was in listed companies on the Icelandic stock exchange. On the OMX Iceland only 9 listed companies were on the stock-exchange in the beginning of 2010. In 2019 listed companies on the OMX Iceland have increased to 19.

4.2 Proxy for The Risk-Free Rate The proxy for the risk-free rate in the research are going to be two indexes. For the first year of estimation, 2010, the OMX Iceland 5-year non-indexed index (OMXI5YNI) is going to be used. From the time period 2011 – 2019 OMX Iceland 10-year non-indexed

(OMXI10YNI) is going to be the proxy for the risk-free rate. This is because the Nasdaq OMX Iceland introduced the OMXI10YNI on February 22., 2011, the index started trading on February 28., 2011. The yield on the index was calculated back to the start of 2011 (Viðskiptablaðið, 2011).

Figure 5. Yields on 5 and 10-year non-indexed government bond index from 2010-2019.

OMX Iceland 5 Year Non-Indexed Yield OMX Iceland 10 Year Non-Indexed Yield

8.25%

7.75%

7.25%

6.75%

6.25%

5.75%

5.25%

4.75%

4.25%

4/1/10 4/1/11 4/1/12 4/1/13 4/1/14 4/1/15 4/1/16 4/1/17 4/1/18 4/1/19 10/1/10 10/1/11 10/1/12 10/1/13 10/1/14 10/1/15 10/1/16 10/1/17 10/1/18

Source: Data retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

The indexes have a fixed duration and can include bullet bonds, bonds with equal installments, annuity bonds and interest rate bonds. There is also no capacity limit for how many bonds can be included at the same time in the indexes, making the index less volatile (Nasdaq Iceland hf., 2011).

Table 7 lists the government bonds included in the indexes over the research period. A 20-year government bond RIKB 31 0124 is the one with the most weight. In the index the RIKB 31 0124 has a fixed duration of 10 years, in the appendix a detailed explanation of the calculations of the index will be found.

Table 7. Constituents of fixed income indexes for the research period.

OMX Iceland 5 Year Non-Indexed OMX Iceland 10 Year Non-Indexed Constituents: Average weight 2010 Average weight 2011-2019 RIKB 13 0517 33.39% RIKB 16 1013 9.66% 0.16% RIKB 19 0226 56.95% 0.88% RIKB 20 0205 0.05% RIKB 22 1026 2.22% RIKB 25 0612 6.98% RIKB 31 0124 90.74% Source: Data retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

The reason why the proxy for the risk-free rate is non-indexed is because the cost of equity is usually stated in nominal terms, including the market expectations of inflation like previously stated in the cost of equity chapter7.

4.3 The Research on Historical Market Risk Premium The historical MRP for Iceland can be determined by analyzing the annual returns on two indexes that include all listed companies on the Nasdaq OMX Iceland main list. The name of those two indexes are OMX Iceland All-Share Gross Index (OMXIGI)8 and OMX Iceland All-Share Price Index (OMXIPI)9. The two indexes include the same constituents at all times but yield different returns. The reason why they yield different returns is because the gross index, OMXIGI, reinvests all dividend payments in the gross index. The price index, OMXIPI, however only yields the performance of stock price movements and does not reinvest dividends in the index. There is not a market capitalization limit on either index to prevent an over-representation of a company or an industry within the index according to Nasdaq Iceland (Magnús Harðarson, personal communication August 19, 2019). The dividend yield of the constituents of the OMX Iceland All-Share creates the difference in the rate of return between the OMXIGI and OMXIPI10.

7 The annual yield for the OMXI5/10YNI is presented in appendix 1 8 In appendix 4 is the gross total return index calculation method. 9 In appendix 3 is the price return index calculation method. 10 In appendix 2 the annaul returns of the OMXIGI and OMXIPI are presented in a table format. 54

Figure 6. Annual returns for OMXIGI and OMXIPI equity indexes including the yield on the OMXI5/10YNI

OMXIGI OMXIPI The risk-free rate

40%

30%

20%

10%

0% 2010 2011 2012 2013 2014 2015 2016 2017 2018 1st quarter -10% of 2019

Source: Data retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

Dividend payments to equity investors are almost non-existent for the first half of the research period like figure 6 shows. The number of constituents of the OMX Iceland All- Share indexes is low in international comparison. In 2010 the number of constituents was 9, that number has since then grown to 19 over the research period.

The historical MRP will be calculated relative to the yield on the risk-free rate as it reflects better the market prices like Koller, Goedhart and Wessels argue.

The historical MRP will be presented using two different averaging methods for both OMXIGI and OMXIPI equity indexes:

1. A geometric average compound each year’s excess return and takes the root of the resulting result: 1 + �� (�) �� = ∏ − 1 1 + �� (�) Where: T = number of observations Rm (t) = the market return in year t Rf (t) = the risk-free rate in year t

2. An arithmetic average, simple average, sums up the premium for each year and divides it with the number of observations: 55

1 1 + �� (�) ��ℎ�� = ∑ − 1 � 1 + �� (�) Where: T = number of observations Rm (t) = the market return in year t Rf (t) = the risk-free rate in year t

The Blume formula that was presented in chapter 3.3 cannot be used for the OMXIGI and OMXIPI indexes because the number of constituents in the index is a variable that is changing frequently within the research period. In 2009 the number of constituents where 9, in 2019 they are 19. The Blume formula would work for an index like S&P500 where the number of constituents is a constant.

To determine if the MRP estimated from the historical data is well equipped to predict what is going to happen in the future a standard error calculation is done on the historical returns using the following formula: ��(��) �� = √� Where: Stdev(MRP) = Standard deviation of historical market risk premium n = number of observations

4.4 The Research on the Implied Market Risk Premium The implied MRP can be estimated from different perspectives, like mentioned in chapter 3.4. How the implied MRP is estimated can be determined by the data available to the researcher. For example, in the dividend discount model, revenue forecast and growth expectations from market analysts are needed. Getting the forecast data can become difficult like the author of this research has encountered. In this chapter the implied MRP is going to be estimated from three different perspectives like Duff and Phelps do to validate their own estimate. Some adjustments are done in order to accommodate the Icelandic market as well as the data that was available during the research.

For two of the three models the OMXI6/8 index is going to be used to represent the Icelandic market. For the first half of the research period, 2010 – midyear 2014, the number of constituents in the index was 6. In July 1, 2014 two new constituents got

56 introduced into the index (Mbl, 2014)11. The OMXI8 index represents the 8 most liquate shares on the Nasdaq Iceland stock exchange. The capped version of the index (OMXI6/8CAP) is reviewed semi-annually, and new composition takes effect on the first trading day of January and July. In the review process a market capitalization (capping) is performed if the market value of the largest index share exceeds 30%, then it is capped at 30%. Other index shares with market value exceeding 15% are capped at 15%. There is also stepwise approach in the daily maintenance of the OMXI8 index, with daily capping performed if the market value of the largest share exceeds 35%, then it is capped at 30%. If another index share exceeds the 20%, then it is capped at 15%. And further if other shares exceed the 15%, then they are capped at 15% (Nasdaq, 2018).

In July 2019 the OMXI8 index became the OMXI10 index, when two new constituents where added to the Index (Viðskiptablaðið, 2019). This change in number of constituents is outside the time period of this research and has consequently no effect on the research. The fluctuation of monthly P/E ratio of the OMXI6/8 index is presented below in figure 7. The data was retrived from Brynjar Örn Ólafsson, who calculates the P/E ratio for the OMXI6/8 index, as well as the cyclically adjusted price-to-earnings ratio (CAPE) from 2005. The P/E ratio is based on the price version of the index (OMXI6/8PI), Ólafsson also adjusts for inflation so both price and earnings numbers in the P/E ratio are real (Ólafsson, 2019). Adjusting for inflation for both the numerator and denominator does not have much impact on the final ratio number. The OMXI6/8/10 that Ólafsson uses is not capped, the weight of individual companies can therefor be significant within the index (Magnús Harðarson, personal communication, August 19, 2019). The P/E ratio was negative for the first quarter of 2010, beacuase the scaled 12 months earnings where negative for the OMXI6/8 index after the financial crises of 2008. Then the P/E ratio sharply increases because earnings became positive, marking the revival of the Icelandic economy. With higher earnings the ratio finds balance right until the 1st quarter of 2019 when a drop in earnings leads to a higher P/E ratio.

11 Also in appendix 5 is an overview of the companies in the index from 2010. 57

Figure 7. P/E Ratio of the OMXI6/8 from 2010-2019

100

-50 12/30/2009 12/30/2010 12/30/2011 12/30/2012 12/30/2013 12/30/2014 12/30/2015 12/30/2016 12/30/2017 12/30/2018

-100

-150

Source: (Ólafsson, 2019).

4.4.1 Discounted Cash Flow Model-Based Premium The methodology used in the research is under the influence of Damodaran. Dividend yield and buyback yield are added together to estimate the total cash to investors. The formula used is the one below: � ∗ � � ∗ � � ∗ � � ∗ � � ∗ � (� ∗ �) ∗ (1 + ��) �� = + + + + + (1 + �) (1 + �) (1 + �) (1 + �) (1 + �) (� − ��)(1 + �) Where: C = Cash to investors: Dividend Yield + Buyback Yield g = Earnings growth gf = Future growth rate r = Required return on equity rf = Risk-free rate

Value of equity is the price of the capped version of the OMXI8 (OMXI8CAP) index.

The dividend yield for the OMXI8 index is determined by calculating the annual difference of returns for the OMXI8GI and OMXI8PI indexes. Like previously discussed in chapter 4.3, the annual difference in returns between the gross (GI) index and the price (PI) index is equal to the dividend yield within the index.

Table 8. Dividend yield on the OMXI8 index 2010-201812

Price Return Dividend Year OMXI8GI OMXI8PI OMXI8GI OMXI8PI yield 2019 1.847,08 1.613,62 0.03% -1.28% 2018 1.846,58 1.634,62 -3.36% -4.44% 1.09% 2017 1.910,71 1.710,61 -6.92% -9.03% 2.11% 2016 2.052,81 1.880,39 49.04% 43.44% 5.61% 2015 1.377,32 1.310,95 6.49% 4.08% 2.42% 2014 1.293,32 1.259,60 20.38% 18.90% 1.48% 2013 1.074,32 1.059,36 17.48% 16.46% 1.02% 2012 914,50 909,66 -2.06% -2.58% 0.52% 2011 933,75 933,75 14.57% 14.57% 0.00% 2010 814,98 814,98 Source: For OMX8GI index (THOMSON REUTERS EIKON 1)., 2019) and for OMXI8PI index (THOMSON REUTERS EIKON 2)., 2019).

The volatility of the dividend yield is evident when looking at the table. Because of the volatility a 4-year average was taken of the dividend yield and used in the calculations. The 4-year average is 2.8%. Of the 8 constituents in the index 4 companies had a buyback program for 2018. The companies are Hagar, Icelandair, Reitir and Siminn. The average buyback yield for the 4 companies is 1.21% making the weighted average for the whole index 0.49%. The buyback yield does not share the volatility of the dividend yield. Cash to investors yield is consequently: 2.8% + 0.49% = 3.29%.

The earnings growth and future growth are forecasts made by market analysts. In Iceland there are research departments both within the banks and independent ones. Unfortunately, in the data collection for the research, only one of the research department was willing to share their 2019 forecast, and no-one older forecasts. Because of that the research on the implied MRP using the cash to investors discounted cash flow method is constrained to 2019. The average earnings growth for the constituents of the OMXI8CAP index is 6.5% and the average future growth rate is 3.67%, Snorri Jakobsson (personal communication, July 11, 2019).13 Taking the average growth for the constituents of the OMXI8CAP would imply that there is an equal weight within the index between constituents. That is not the reality as has been covered in the beginning of the chapter, with capping taking place in the index. To estimate both the revenue growth and the future

12 Data retrived via Thomson Reuters account. 13 Information retrived via email from Capacent 59 growth for the OMXI8CAP index the weight of a company in the index is multiplied by its growth forecast to estimate a total weighted revenue growth and future growth for the index. The weighted index growth after 1st quarter of 2019, on April 1 is a revenue growth of 6.24% and a future growth of 3.52%.

The earnings and growth forecast became available to investors during and after 1st quarter of 2019, Snorri Jakobsson (personal communication, August 22, 2019). To accommodate the research period the price of the OMXI8CAP index is going to be the price on April 1, 2019.

The proxy for the risk-free rate is the same as throughout the research, the calculations using the discounted cash flow model are limited to 2019 so OMXI10NI yield on the same day as the price of the OMXI8CAP is the proxy for the risk-free rate, April 1, 2019.

Required return on equity can be easily calculated in excel using the solver function. By using CAPM for the whole market, the beta is equal to 1, the formula for the required return is simply: the risk-free rate plus the implied premium.

4.4.2 Default Spread Model Based Premium Since Iceland has not had an Aaa Moddy´s rating after the financial crises of 2008, calculating a default spread for the Icelandic market requires compromise. The compromise could be to use a rating-based default spread to create a country risk premium for the Icelandic market. The default spread based on the A3 credit rating for Iceland is 1.35% like table 5 shows. Country risk premium can be determined including the volatility of equity markets or not. Damodaran has calculated the country risk premium for Iceland, accounting for the volatility of equity markets, using the last 5-year ICE BofAML Public Sector Issuers Emerging Markets Corporate Plus Sub-Index Effective Yield (BAML) and measuring it against S&P emerging broad market index (BMI). The BAML index includes all quasi-government securities as well as the debt of corporate issuers designated as government owned or controlled by ICE BofAML emerging markets credit research (ICE Benchmark Administration Limited (IBA), 2019). The standard deviation of daily yield of the BAML index is divided with the average yield for the same index to estimate the bond spread. The daily standard deviation of returns for the equity index is annualized and divided with the bond spread to estimate the relative volatility of 1.23 (Damodaran A. 1., 2019).

Multiplying the relative volatility against the default spread gives a country risk premium of 1.67% for Iceland. After estimating the country risk premium it’s only a matter of finding the relative base premium for a mature equity market to get an estimate on the MRP. �� = �� + �� This method can be useful to validate other methods to see if estimates are in similar range.

Below are 8 countries whom all consist of equity markets that have available data on the historical MRP from 1900, implied MRP and a required MRP, that have all been presented in the previous chapters. The mature equity markets all share the same credit rating from Moody’s, a Aaa rating. Because of the shared characteristics of the equity markets they can all serve as a base market for mature equity market. The markets used are the following: - Australia - Canada - Denmark - Germany - Netherlands - Sweden - Switzerland - United States

The base premium is going to be presented using three types of MRP for each market, historical, implied and required that can be found in tables 1, 3, 4, and 6. The historical MRP is the geometric mean of data from 1900 – 2017. Presented in table 1. The implied MRP for the United States is the implied premium from Damodaran for 2019 in table 3. For rest of the countries Fenebris implied MRP is used, table 4. The required MRP is a survey premium from Fernandez listed in table 6.

The MRP is going to be calculated both with and without additional volatility of equity markets. Without accounting for the additional volatility of equity markets the country risk premium equals the default spread.

4.4.3 Risk Premium Factor Implied Market Risk Premium Model Implementing Steve Hassett implied MRP model to the Icelandic market requires three variables: P/E ratio, risk-free rate and growth expectations. After obtaining those variables it is simply a question of solving for the risk premium factor (RPF) in the following formula: = (∗()) Where: P = Price E = Actual annualized Earnings Rf = Risk-free rate RPF = Risk premium factor G = The expected nominal long-term growth rate, broken down to real growth and inflation

The time period is from 2010 – 1st quarter of 2019. For the 1st quarter of 2010 earnings are negative for the OMXI6/8 index. Because of that adjustments are made for the time period, starting at 2nd quarter of 2010 when earnings become positive. The model is limited to positive earnings. The P/E ratio is gathered from Brynjar Ólafsson for the OMXI6/8PI. The risk-free yield curve is the same as for the historical market risk premium, OMXI5YNI for 2010 and OMXI10YNI for the remainder of the time period. Growth expectations are gathered from the central bank of Iceland, the central bank publishes both a 3-year GDP forecast, and an inflation forecast four times over a year in their issue Monetary Bulletin (The Central Bank of Iceland, 2019). For the research on the implied MRP the three-year forecast in the beginning of the year is used as growth expectation for the whole year. Growth is then calculated using the nominal interest rate formula: ��ℎ = (1 + �� ) ∗ (1 + �� ) − 1

Table 9. Growth expectations from the Monetary Bulletin from the Central Bank of Iceland.

3-year GDP 3-year inflation Year forecast forecast Growth 2010 0.97% 3.93% 4.94% 2011 3.07% 2.04% 5.17% 2012 2.48% 3.36% 5.93% 2013 3.20% 2.99% 6.28% 2014 3.01% 3.10% 6.21% 2015 3.27% 1.91% 5.24% 2016 3.50% 3.22% 6.83% 2017 3.65% 2.50% 6.24% 2018 2.95% 2.51% 5.53% 2019 2.39% 2.92% 5.39% Source: (The Central Bank of Iceland, 2019).

With the all the data from above ready, there is nothing in the way of plugging the numbers into the risk premium factor formula, to estimate a monthly implied MRP. � + � − �� = � �� Where: E/P = Invers P/E ratio G = Growth Rf = The risk-free rate A geometric and an arithmetic average is then taken of the implied MRP to estimate a single number MRP for the whole research period.

4.5 Interviews Conducting a survey on the expected and required MRP could not be done in the research. To get an insight into how market participants and analyst estimate cost of equity and use MRP in their work a number of interviews was conducted. The type of interview used in the research is a semi structured one, with number of predefined questions. The questions that where asked during the interview are the following: 1. What model do you use in your cost of equity estimations? 2. What is your proxy for the risk-free rate? 3. What is your market risk premium for the Icelandic market? 4. Is your market risk premium estimate based on historical returns? 5. Is your market risk premium estimate based on implied premium?

6. Is your market risk premium estimate based on surveys? 7. In your opinion do you think that there is a link between the risk free-rate and the market risk premium in a way that, when the risk-free rate increases the market risk premium does to and vice versa?

All the questions, except the last one, include follow up questions that can be viewed in appendix 614. Questions 1, 2, 3 and 7 are open ended ones to allow the participants to answer in their own terms and make room for new and unexpected answers. Questions 4, 5 and 6 are narrower yes and no questions with only a follow up question if the answer is positive. The interviews are in-depth to provide a qualitative approach to the research in order to get the insight into practices of market participants and analysts. The biggest advantage of in-depth interviews is the detailed information that can be gathered from the interviewee (Boyce & Neale, 2006).

4.5.1 Participants When choosing the participants for the interviews the benchmark was to include people who are estimating the cost of equity on almost daily basis. From that group of people, it is important to get as broad of a perspective as possible. That’s is why KPMG valuation specialist, market analysts from research departments where chosen for the interviews. The MRP seems to be in similar range between market practitioners and analyst and therefore not a need to interview more than 5 individuals. Of the 5 interviews only 3 are reported as the other 2 did not add anything substantial to the research.

4.5.2 Data Process The interviews are conducted in Icelandic, as all the participants are from Iceland. The interviews are recorded with the acceptance of the interviewee. Then they are translated to English and reported in the result chapter of the research after the interviewee has reviewed and accepted the reporting. The common practice is to transcribe in-depth interviews creating a verbatim text (Guion, Diehl, & McDonald, 2001). That has been debated in literature: Halcomb and Davidson argue in their research that verbatim transcription of interview data is not always necessary. Basing their argument for mixed method researches it can be unnecessary to transcribe all audio recorded interview data

14 The full interview guide is available in appendix 6 64 verbatim (Halcomb & Davidson, 2006). The answers from the interviews are analyzed and summed up to present the topics that the interviewees found most important.

5. Results from the Research The aim of the research is to show the reader the importance of the MRP in cost of equity estimations. The MRP is one of the three variables that make the CAPM model, the beta is multiplied with the MRP and the risk-free rate added on top of that to estimate the cost of equity, previously covered in chapter 2.6.2. CAPM is the most used model to estimate cost of equity both in Iceland and the rest of the world, like the finding from literature and the interviews suggest.

Because the MRP is a forward-looking concept there isn’t a universally accepted way to estimate it. In this research four different methods are used to estimate the range of the MRP in Iceland for the time period 2010 – 1st quarter of 2019.

There is no official data available from a neutral institution in Iceland what the MRP should be. Government institutions rely on estimates from financial specialists like those mentioned in the beginning of chapter 4, such as ministry of industries and innovation who stated in a regulation that the MRP should be 5%. Private corporations estimate the MRP using their own methods according to the interviews.

In the following sub-chapters the MRP is going to be estimated based on historical returns, dividend and buyback discounted cash flow model, country risk premium and risk premium factor model. The results from the models are going to be compared to foreign MRP estimates to see if the Icelandic market is in the same range as other countries. To complement the findings from those models, interviews from market practitioners and analysts are analyzed to compare the MRP estimate in this study to the one used by the experts in the field of finance in Iceland.

5.1 Results on the Historical Market Risk Premium When calculating MRP from historical data the biggest challenge is to assemble a data set with standard error as low as possible. Analyzing shorter time periods will lead to higher standard error of the data set. It is possible to increase data points by using monthly returns instead of annual returns.

The effect on the standard error is minimal. By using monthly returns, the annualized standard error is 4.22% for the OMXIPI all share index, using annual returns for the same

index15 the standard error decreases to 3.99%. The fact that the annual returns have lower standard error to begin with, annual returns are only going to be presented and used in the research.

Geometric average is preferred over arithmetic average to present the historical MRP, since the arithmetic average is too biased upwards to give a reliable estimate of the MRP. Also, the geometric average mirrors better the returns investors in the market receive in reality with investments defined as risk investments as opposed to risk-free investments having fluctuations in their returns. The arithmetic average can be seen in table 10 to accommodate the geometric average.

The historical MRP adjusted for dividend payments is 6.72% over the time period. Including the effect of dividend payments, the market return declines leading to a lower historical MRP, 5.02%.

Table 10. Historical Market Risk Premium based on annual returns from 2010 - 1st quarter of 2019.

Historical market risk premium based on annual returns from 2010-1st quarter of 2019 Index Geometric average Arithmetic average Standard error OMXIGI 6.72% 7.50% 4.13% OMXIPI 5.02% 5.76% 3.99% Source: Calculated by the author. 5.2 Results on the Implied Market Risk Premium The implied MRP was estimated using three different methods. The three methods are drawn from Duff and Phelps (Duff & Phelps, 2016) and depend on different types of data to estimate the MRP.

5.2.1 Results on the Discounted Cash Flow Model-Based Premium The inputs into model are the following:

The price of the OMXI8CAP on April 1, 2019 was 1.592,47 ISK.

To determine the cash to investors the dividend yield and buyback yield for the index is calculated. The dividend yield is 2.8% and buyback yield is 0.49%. Multiplying the yields to the price of the index and then summing them together equals cash to investors. The calculations are presented in table 11.

15 Annual returns for the OMXIGI and OMXIPI indexes are presented in appendix 2 67

Table 11. Cash to Investors for the OMXI8CAP Index 2019

Price 1/4/2019 Dividends Buybacks Cash to Investors

OMXI8CAP: 1.592,47 44.66 7.78 52.43

Source: Calculated by the author. With cash to investors equaling 52.43 ISK for year 0 in the model, the next phase is to calculate the cash flow to investors for year 1, 2, 3, 4, 5 and a terminal value. That is done with the weighted revenue growth forecast (6.42%) and future growth forecast (3.52%) for the index based on data from Snorri Jakobsson (personal conversation, July 11, 2019).

After calculating the future cash flows for the index, all variables are ready to be plugged into the discounted cash flow formula.

The risk-free rate is equal to the yield on the OMXI10YNI index on April 1, 2019. 4.42%. Table 12. Discounted Cash Flow Model for OMXI8CAP April 1, 2019.

Year 1 2 3 4 5 terminal value Cash to investors: 55.80 59.39 63.20 67.26 71.58 74.10 PV of cash to investors: 51.60 50.77 49.96 49.16 48.38 1.342,60 Intrinsic value of OMXI8CAP: 1.592,47

Source: Calculated by the author. Using the excel function Solver it’s fairly simple to calculate the implied MRP from the discounted cash flow model. The present value (PV) of cash to investors is calculated with the following formula: ��ℎ �� = (1 + �) Where: Cash to investor = The cash flow for year n r = The discount factor, for the market its equal to the risk-free rate + implied market risk premium. n = year of the cash flow being discounted.

After setting all the assumptions correctly in the excel sheet it’s only a matter of asking solver to match the intrinsic value of the OMXI8CAP to the price of the index April 1, 2019.

By changing the discount factor, to get the intrinsic value to match the original value the discount factor becomes 8.15%. The risk-free rate in the calculations equals 4.42%, by deducting the risk-free rate from the discount factor the resulting implied MRP for the OMXI8CAP is 3.73%.

5.2.2 Result on the Default Spread Method The aim of this approach is not to find a specific MRP, but rather to determine a range that the MRP should be within using data from multiple markets as well as different types of MRP.

The methodology is to take the credit spread and country risk premium calculated for Iceland and add that on top of different base premiums for mature equity markets. This will serve as good indicator in what range the MRP should be for the Icelandic market using data from multiple markets.

The credit default spread for Iceland is 1.35% and the country risk premium is 1.67% for 2019.

The countries in the tables below are chosen because they share the following characteristics: • They all have an Aaa Moody’s rating. • Available data from Dimson, Marsh and Staunton from 1900-2017 on historical MRP relative to bonds. • Implied premium from Fenebris as well as Damodaran (only the U.S market). • A required MRP from 2019 via survey from Fernandez.

In the table on the next page the historical, implied and required MRP are listed.

Table 13. Base Premiums for mature equity markets with a Aaa Moody's credit rating 2019.

Base Premium for Mature equity market Market Historical MRP Implied MRP Required MRP Australia 5.00% 4.61% 6.50% Canada 3.50% 5.48% 5.80% Denmark 2.20% 5.16% 6.00% Germany 5.10% 6.81% 5.70% Netherlands 3.30% 6.53% 6.00% Sweden 3.10% 5.54% 6.10% Switzerland 2.20% 6.31% 6.20% United States 4.40% 5.96% 5.60% Source: Historical MRP (Dimson, Marsh, & Staunton, 2018). Implied MRP (Kaserer, Willershausen, Berg, & Kittlauss, 2019) and Implied MRP U.S (Damodaran A. 2., 2019). Required MRP (Fernandez, Martinez, & Acín, 2019). The average MRP from all the different types of base premiums is 5.13%. The lowest premium being the historical MRP for Denmark, 2.20%, and the highest is the implied MRP for Germany, 6.81%.

The numbers in table 14 are relatively straight forward, simply using the formula: �� = �� + ��

By using the formula, a possible MRP for Iceland is obtained.

For the first part of the research on country risk premium, volatility of emerging equity markets is dismissed in the calculations. The country risk premium is then equal to the default spread, 1.35%. The country risk premium is added on top the base premiums presented in table 13.

The average using historical premium as a base including all the countries in the table is 4.95%. The average using implied premium as a base is 7.15% and 7.34% when using the required premium as a base. The total average including all the premiums, rises by 1.35% from the base premium average to 6.48%.

Table 14. Possible MRP for Iceland using Default Spread on top of base premium from various countries.

Base premium + Default Spread (1.35%) for Iceland Base market Historical MRP Implied MRP Required MRP Australia 6.35% 5.97% 7.85% Canada 4.85% 6.83% 7.15% Denmark 3.55% 6.51% 7.35% Germany 6.45% 8.16% 7.05% Netherlands 4.65% 7.89% 7.35% Sweden 4.45% 6.90% 7.45% Switzerland 3.55% 7.66% 7.55% United States 5.75% 7.31% 6.95% Source: Calculations from the author, based on data from table 13.

In table 15, the country risk premium includes the volatility of emerging equity markets. The volatility equals 1.23 and by multiplying that number to the default spread sees the country risk premium rise to 1.67%. The base premiums are again from table 13. The average MRP using historical premium as a base becomes 5.27%, 7.47% when using implied premium as a base and 7.65% when using the required premium as a base. The total average becomes 6.79%.

Table 15. Possible MRP for Iceland using Default Spread multiplied with the volatility of emerging equity markets.

Base premium + Country risk premium (1.67%) for Iceland Base market Historical MRP Implied MRP Required MRP Australia 6.67% 6.28% 8.17% Canada 5.17% 7.15% 7.47% Denmark 3.87% 6.82% 7.67% Germany 6.77% 8.47% 7.37% Netherlands 4.97% 8.20% 7.67% Sweden 4.77% 7.21% 7.77% Switzerland 3.87% 7.98% 7.87% United States 6.07% 7.63% 7.27% Source: Calculations from the author, based on data from table 13. Like stated in the beginning of this chapter, the aim was to determine a range that the MRP could be in. The lower limit of that range is then the average of the base premiums, 5.13%. The upper limit could be the average MRP found in table 15, 6.79%.

5.2.3 Results on the Risk Premium Factor Implied Market Risk Premium Model Because of negative earnings in the in the beginning of 2010, the model starts April 30, 2010 when the P/E ratio becomes positive. 2010 reflects the ¾ of the year and 2019 only the 1st quarter of the year. The time period of the model is 9 years.

Because the risk premium factor is recalculated monthly there is a negative correlation between the risk-free rate and the MRP. The calculated correlation is -0.52.

The formula for risk premium factor is the following: � + � − �� = � �� Where: E/P = Inverse P/E ratio G = Growth Rf = The risk-free rate

The risk premium factor changes as the variables in the formula change. In figure 8, the fluctuation of these variables during the research period are presented. Figure 8. Fluctuation of the variables in the Risk Premium Factor model for the time period

E/P G Rf

11.00% 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 4/30/10 4/30/11 4/30/12 4/30/13 4/30/14 4/30/15 4/30/16 4/30/17 4/30/18

Source: Calculated by the author. P/E from (Ólafsson, 2019). Growth from (The Central Bank of Iceland, 2019) and risk-free rate retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

Figure 9 shows the relationship that the MRP has with the risk-free rate. The correlation between the two variables is -0.52.

Figure 9. RPF Implied Market Risk Premium correlation with the Risk-Free Rate

Risk free rate Market risk premium 12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00% 4/30/10 4/30/11 4/30/12 4/30/13 4/30/14 4/30/15 4/30/16 4/30/17 4/30/18

Source: Market Risk Premium calculated by the author. Risk-Free Rate retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

The average yearly MRP for the time period is presented in the table below using both a geometric and arithmetic average.

Table 16. Annual Average Implied Market Risk Premium from the RPF model.

Year Geometric average Arithmetic average 2010 3,77% 3,78% 2011 4,35% 4,37% 2012 6,02% 6,02% 2013 6,13% 6,13% 2014 5,75% 5,65% 2015 4,83% 4,83% 2016 9,00% 9,00% 2017 9,18% 9,18% 2018 6,01% 6,02% 1st Q 2019 3,03% 3,03% Source: Calculated by the author based on data from: P/E from (Ólafsson, 2019). Growth from (The Central Bank of Iceland, 2019) and risk-free rate retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

To get the best estimate of the MRP that is backed by statistically significant data I recommend using the whole time period to get a single number as the MRP for Iceland. 73

That single number can either be generated with a geometric or an arithmetic average. The difference between the two averages is minimal.

Table 17. RPF Market Risk Premium for Iceland 2010-2019

RPF Market Risk Premium Geometric average: 6.08% Arithmetic average: 6.10% Source: Calculated by the author based on data from: P/E from (Ólafsson, 2019). Growth from (The Central Bank of Iceland, 2019) and risk-free rate retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

The results from regressing the data set using the risk premium factor as the Y variable and P/E ratio, growth and the risk-free rate as the X variable are the following:

Figure 10. Regression statistics for RPF factor using data from 2010-2019

Regression Statistics Multiple R 0,95879926 R Square 0,91929602 Adjusted R Square 0,91696802 Standard Error 0,13165067 Observations 108

Coefficients Standard Error t Stat P-value Intercept 2,11758417 0,19993987 10,5911049 3,2161E-18 P/E ratio -0,0260593 0,00197363 -13,203709 5,7481E-24 Risk free rate -36,083763 1,47143216 -24,522886 4,9465E-45 Growth 27,1988367 2,44545028 11,1222202 2,1085E-19 Source: Calculated by the author.

The P-values for the X variables are all sufficient at a 1% level. A calculated annual standard error for the implied MRP over the research period using the same formula as in the historical MRP calculations is 2.39%. That is substantially lower than the standard error from the historical MRP and gives a good indication of the predictability of the calculations.

To summarize the findings from the risk premium factor model. The geometric average MRP for the research period is 6.08%. According to the model the implied MRP for the

1st quarter of 2019 is 3%. That is in similar range as the implied MRP found in chapter 5.2.1.

5.3 Results from the Interviews In the following chapters the answers from the interviews are going to be analyzed and summed up. The important take away points from the interviewees will be reported in the following sub chapters with main emphasis on the answers to the questions in the interview guide.

5.3.1 Magnús Gunnar Erlendsson KPMG Partner and Valuation Specialist When asked what model he used to estimate cost of equity Magnús replied that CAPM was the preferred model. KPMG is mainly estimating the cost of equity for unlisted companies, a modified version of the CAPM is then used which includes an alpha that determines the small-company premium and risk premium related to specific risk factors such as country risk, inflation risk and liquidity risk. The calculations are done in nominal terms and the same methodology is used for foreign companies as well. The method is based on global guidelines from KPMG on how to estimate WACC. There can be exceptions from the guidelines for example when estimating Icelandic real-estate companies, they have both index-linked debt and revenue. Cost of equity is then done in real terms using index linked risk-free rate.

Magnús usually preferers the government bond with the longest maturity time as the proxy for risk-free rate in Iceland. Abroad the duration on the risk-free rate is the same as on the cash flow for the company in question. The most common duration is from 15 to 20 years assuming perpetual lifetime of cash flows. After the financial crises of 2008, there was a sharp decline in yields on short term government bonds leading practitioners to choose bonds with longer maturity to decrease the volatility between time periods. The risk-free rate is in the same currency as the cash flow being valued.

According to Magnús the MRP for the Icelandic market is 6% and has been 6% for the last 2 or 3 years. The MRP is revisited annually, where a decision is made in December what should be the appropriate MRP for the following year. That is in line with what KPMG is doing globally. In accounting KPMG has approved a MRP in the range from 5% to 7%.

The MRP used by KPMG has increased from their last estimate, it was 5.5% before and was changed in the beginning of 2017 to 6%. KPMG is going to analyze the price development for companies against the yield curve and if the results are that prices are not following the yield curve a decision will be made to increase the MRP for 2020. If the MRP would remain unchanged then KPMG will be overestimating company valuations.

When Magnús was asked if KPMG based their MRP on historical returns his answer was no. Mainly because it is hard or impossible to get a statistically significant data from historical returns in Iceland.

KPMG MRP estimate is based on implied approach. Damodaran, Fernandez and Duff & Phelps, who all publish their estimate for the MRP are used by KPMG to validate their own estimate of the MRP. KPMG uses free cash flow to firm against WACC to solve for MRP for unlisted companies. Corporations faced with some sort of capital restrictions, e.g. banks and insurance companies, are estimated using dividend yield. Earnings are used as a secondary method to validate other estimates. Country risk premium is not used when using Icelandic risk-free rate. KPMG believes that the country risk is already included in the domestic risk-free rate as well as inflation risk. When estimating companies like travel agencies and other companies with revenue in foreign currency, the risk-free rate is from the same country as the main source of revenue and the MRP includes a country risk premium to include the factors mentioned above in the cost of equity estimation.

When asked if surveys are used to estimate the MRP Magnús replied no, but he has always liked the idea of conducting a survey, but time and resources have not been available to make that happen. The focus on that survey would be on market analyst and CFO’s. There is a template survey available from KPMG global network that could be used as a model for a domestic survey.

Magnús has a feeling that the relationship between the risk-free rate and the MRP is negative. The feeling is based on the required cost of equity from investors that is negatively correlated with the yield on risk-free rate. Investors still want 15% cost of their

76 equity despite the risk-free rate being 3% or 7%. The MRP then becomes a variable that balances out the volatility in the yield on the risk-free rate.

5.3.2 Snorri Jakobsson Capacent Research Department Manager Expert Snorri’s reply to the question what model he used in his cost of equity estimations was CAPM. When calculating the cost of equity for companies Snorri always uses additional specific risk measures on top of the risk-free rate, beta and MRP. The specific risk premium can be from different reasons related to the characteristics of the company that’s being valued. This includes for example information disclosure, stability of operations, founding and competition in the sector. Most of the cost of equity calculations are done in real terms because historically the inflation in Iceland has been high. Including inflation can therefore distort estimations. Future growth for companies in sectors such as real estate cannot expect growth to exceed population growth like Robert Shiller wrote in his book Irrational Exuberance. Financial institutions and insurance companies are estimated using nominal numbers because a big part of the valuation is to estimate the returns on investment portfolios. Foreign companies are also done on nominal terms, mainly because of lack of index linked government bonds to use as a proxy in cost of equity calculations.

Snorri’s proxy for the risk-free rate is the government bond with the longest maturity both for the index linked and non-index linked bonds. For the nominal calculations the RIKB31 is used and for the real calculations the RIKS30 is used.

The MRP for the Icelandic market is different between companies. Ranging between 5% and 6%. The difference between companies comes from the source of revenue. Companies that have revenue stream in foreign currency have a lower MRP that companies with domestic revenue stream. Difference comes from country risk premium being added on companies with domestic revenue stream. Snorri believes that the MRP has been increasing since the capital controls were lifted, based on market prices on listed companies.

When asked if the estimate for the MRP is based on historical returns Snorri replied yes. He was not sure what the benchmark for market returns was and also what the period for that historical MRP was.

Capacent uses the same model as Duff & Phelps to estimate their MRP. The MRP is a variable that changes in reverse to the risk-free rate. Preventing the discount factor to become lower with lower yields on risk-free rate that will translate into higher stock prices.

The relationship between the risk-free rate and MRP listed above is consistent with the view that Snorri has on the relationship between the two variables. That when there is an upswing in the economy, yields on government bonds increase and the MRP decreases since the risk of investing in equity´s is smaller. And vice versa.

5.3.3 Þorsteinn Andri Haraldsson Equity Analyst at Arion Bank When asked what model he used in his cost of equity estimations Þorsteinn replied that CAPM was the preferred model. The calculations are nominal because including inflation gives a better picture of how the future is going to look like. The inputs in the CAPM are largely drawn from Damodaran and can include specific risk factors dependent on the characteristics of the company being valued.

The proxy for the risk-free rate is usually the outstanding government bond with a maturity closest to 10 years. RIKB28 is currently the proxy for the risk-free rate. The reason why Þorsteinn wants to be as close to a 10-year maturity as possible is to match the duration of cash flows in their forecasting models. When estimating companies with revenue in foreign currencies the weight of the composition of revenue stream is estimated to find the relevant source for the risk-free rate.

The MRP for the Icelandic market is around 6.7% based on an estimate from Damodaran. The estimate is revisited semi-annually and changed in line with market developments.

When asked if the MRP was based on historical returns Þorsteinn replied no, not for the Icelandic market. He believes that the market is too small and inefficient to get reliable data from it.

The MRP that Þorsteinn uses is based on an implied approach. Because of the inefficiency of the Icelandic market Þorsteinn uses a base premium from a mature equity market and adds on top of that a country risk premium based on sovereign CDS, net of the US market. The base premium is the implied MRP on the S&P500 from Damodaran.

Arion Bank used to survey investors about their required MRP. With declining participation of investors in the survey the data from it became insignificant and Arion canceled the survey. Þorsteinn would not rule out the possibility of reviving the survey at some point in the future.

Asked about the relationship between the risk-free rate and the MRP, Þorsteinn replied that his feeling until this summer has been that there was a positive link between the MRP and the risk-free rate. What happened this summer is that there was a sharp decline in the risk-free rate and the reaction of market participants has been to increase the MRP in order to stabilize cost of equity estimations. Today Þorsteinn feels that there is not a clear relationship between the two variables.

6. Conclusion and Discussions After examining the MRP for the Icelandic market from different perspectives and getting different outcomes, the next part of the research is to determine the range that the MRP should be in when estimating the cost of equity. In order to be able to do that the results are going to be analyzed and compared to the MRP in other markets that where covered in chapters 3.3 to 3.5.

6.1 Conclusion on the Historical Market Risk Premium The indexes used to estimate the historical MRP are the OMXIGI and OMXIPI all share indexes from Nasdaq Iceland. They are the two indexes that come closest to fulfilling the requirements that Dimson, Marsh and Staunton set out when researchers choose index. Out of the two indexes, OMXIGI is better because it adjusts for dividend payments and therefore shows the total returns of the market. The downside of both indexes is that they are not capped and because of that the weight of the companies with the highest market value can be and is quite high in the index.

With OMXIGI the preferred index out the two, and like covered before a geometric average is a better measurement of historical returns that an arithmetic average. The historical MRP for Iceland for the research period is then 6.72% with a standard error of 4.13%.

When comparing both the MRP and the standard error to the historical MRP relative to bonds 1900-2017, presented in table 1, it is clear that using longer time periods leads to a lower standard error. A lower standard error increases the credibility that historical returns are going to happen again in the future. Like stated in the beginning of chapter 3.3, when using historical MRP, a key assumption is made that the past is going to mirror the future.

The standard error for the time period in the research is much closer to the data presented in table 2, where shorter time period is used to estimate the historical MRP. Damodaran claims that data with standard error of that magnitude cannot be taken too seriously and goes on to claim that it is close to useless.

When comparing annual returns on the equity market against the returns received on the fixed income market, based on the returns on the proxy for the risk-free rate. An

80 interesting picture emerges. Government bonds outperform the annual returns on the equity market adjusted for dividend payments (OMXIGI) five times: 2010, 2011, 2016, 2017 and 2018. The cumulative return of the OMXIGI for the research period is 131.24% and the combined cumulative returns of the OMXI5YNI and OMXI10YNI is 87.59%.

Figure 11. Annual Returns of the OMXIGI vs. the Annual Returns of the proxy for the Risk-Free Rate.

OMXIGI OMXI10YNI OMXI5YNI

45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% 2010 2011 2012 2013 2014 2015 2016 2017 2018 1st quarter of 2019

Source: Data retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

The geometric average of the difference of returns between the OMXIGI and OMXI5/10YNI is 4.01%.

To summarize: The historical MRP (6.72%) is both in the upper limit of the range of what is currently being used today in Iceland according to the interviews (6.7%) and the country risk premium using data from multiple markets (6.73%). That could be used as an argument for using the historical MRP in cost of equity calculations. The magnitude of the standard error of the calculations are arguments against using the MRP obtained from historical returns. It could be interesting to measure the historical MRP in Iceland further back in time and dismiss the bubble phase and the financial crash that followed in that calculation. That would increase the estimation period and should give the researcher a lower standard error. I would recommend doing that in further research on the historical MRP in Iceland.

6.2 Conclusion on the Implied Market Risk Premium The implied premium was studied from three different perspectives in the research, using different types of data to estimate the MRP. In the field of financial literature, it can be debated if the value of companies should be derived from its dividend payments or earnings. To accommodate the different views in valuation the MRP is estimated using both approaches as well as a multi-national approach using a mature market for a base premium and adding a country risk premium on top of that.

6.2.1 Conclusion on the Discounted Cash Flow Model Based Premium The outcome of the model is an implied MRP of 3.73%. That is extremely low when compared to other markets as well as the MRP used by Icelandic market participants reported in the interviews.

An implied MRP of 3.73% is lower than all estimates from Damodaran inside the research period presented in table 3. When comparing the result to the implied premiums from Fenebris in table 4, only India and South Africa have a lower implied MRP.

There could be few reasons why the MRP is so low. When calculating the implied MRP with the dividend discount method including buybacks one needs to be aware of the variables that have big impact in the final results. Like mentioned in chapter 3.4.3 different expectations of growth will lead to different implied MRP. The fact that the growth expectations only comes from one market analyst creates the first problem, the implied MRP only reflects the growth expectations of that analyst. To get a good reflection of the market a growth forecast from all the main research departments issuing equity analysis for the Nasdaq OMX Iceland would be needed. In Iceland they are four, with Landsbankinn, Arion Bank, Capacent and IFS all issuing such reports.

Another problem is the index used as a proxy for the market, OMXI8CAP. The assumption is made that the beta for OMXI8CAP is equal to 1. The index only includes 8 companies and Marel is the company with the biggest market cap and a weight of 33.12% in the Index on the day of the calculations April 1, 2019. Adding the companies with the second and third largest market cap, Hagar and Icelandair group, the combined weight of the three constituents rises to 55.17% in the index. There is no official data

82 available on the beta for the index or the companies. A potential explanation for the low MRP could be that the beta for the index does not equal 1 and is in fact higher.

Taking these concerns into consideration, future studies on the subject should be done with revenue and future growth forecast from the research departments listed above. The OMXI8CAP index has seen its constituents rise to 10, so it should represent the market better. However, 10 constituents are still very low in international comparison and future studies should consider using the all-share index.

Best practice could be to solve for the implied MRP for each listed company based on its share price, dividend yield, buyback yield, 5-year revenue growth forecast and future growth forecast. Then take the average of all companies to determine the MRP for the whole market. That method is very time consuming and would suite a group to solve.

To summarize: The implied MRP is not in the range of what could be considered a normal MRP for Iceland or for other mature equity markets. An implied MRP of 3.73% should not be used as the MRP in cost of equity calculation as it would lead the practitioner to underestimate the cost of capital and that could lead to acceptance of bad projects that in reality have negative net present value.

6.2.2 Conclusion on the Default Spread Method The biggest advantage of the default spread method is that the data used to estimate the MRP comes from markets proven to be efficient. The problem is to decide what market and what type of MRP should be used as a base premium for a mature equity market to add the country risk premium on top, especially when the revenue stream is in domestic currency. When the revenue stream is in foreign currency the base premium should be consistent with the main source of revenue.

With Iceland a member of the European Economic Area (EEA) and the European Free Trade Association (EFTA) it could be argued that the base premium should be from a market in the European Union, Denmark, Germany, Netherlands or Sweden. Switzerland is also an option as it is a member of the EFTA.

In the interview with Þorsteinn at Arion Bank he confirmed that the he and the bank used the implied MRP from Damodaran as a base premium. That is also the case with Landsbankinn. 83

The biggest flaw of the method when adding the default spread on top of a base premium is that the default spread premium is already included in the calculations when beta equals 1 at least. The domestic risk-free rate includes the default spread so by adding it again to the MRP would lead to the default spread being calculated twice.

Magnús Gunnar Erlendsson shares that view like stated in the interview in chapter 5.3.1. To prevent the default spread to be calculated twice Landsbankinn deducts the default spread from the risk-free rate, this adjustment makes the default spread connected to the beta in cost of equity calculations (Hagfræðideild Landsbankans, 2016).

After agreeing on what market is best positioned to represent the base premium, another discussion has to take place on what type of MRP from that market should be used. In chapter 3.2 the different types of MRP are listed, based on data these premiums do not equal one and other. In this research the expected MRP was not included as an option but with sufficient data it could easily be included.

The last question would be if the volatility of emerging equity markets should be included in the country risk premium or not. By including the volatility, the country risk premium increases and that leads to a higher MRP.

When using the default spread method these questions would need to be answered. The premiums highlighted green are in the range from 5.13% to 6.73%. 5.13% is the average from all the suggested base premiums and 6.73% is the average from all the base premiums plus the country risk premium including the volatility of equity markets. This range is also similar to the MRPs used by the interviewees.

Table 18. Highlighted Premiums using Default Spread Method

Base premium + Default Spread (1.35%) for Iceland Country Historical premium Implied premium Required premium Australia 6,35% 5,96% 7,85% Canada 4,85% 6,83% 7,15% Denmark 3,55% 6,51% 7,35% Germany 6,45% 8,16% 7,05% Netherlands 4,65% 7,88% 7,35% Sweden 4,45% 6,89% 7,45% Switzerland 3,55% 7,66% 7,55% United States 5,75% 7,31% 6,95% 84

Source: Calculations from the author, based on data from table 13.

Table 19. Highlighted Premiums using Default Spread multiplied with the volatility of emerging equity markets

Base premium + Country risk premium (1.67%) for Iceland Country Historical premium Implied premium Required premium Australia 6,67% 6,28% 8,17% Canada 5,17% 7,15% 7,47% Denmark 3,87% 6,83% 7,67% Germany 6,77% 8,48% 7,37% Netherlands 4,97% 8,20% 7,67% Sweden 4,77% 7,21% 7,77% Switzerland 3,87% 7,98% 7,87% United States 6,07% 7,63% 7,27% Source: Calculations from the author, based on data from table 13. Required premiums are higher than the historic and implied ones, adding a default spread on top of them creates an MRP that is probably too high.

To summarize: The main source of revenue can be used as an argument for the choice of base premium. If the main source of revenue is domestic, then it is really up to the practitioner to decide what market he/she uses for a base premium. The range of the MRP using the equity markets in the tables is from 5.13% to 6.73%. MRP outside of that range would need solid arguments to be validated.

6.2.3 Conclusion on the Risk Premium Factor Implied Market Risk Premium Model The biggest advantage of the risk premium factor model is the availability of data that is required to put into it. The only compromise that was needed was regarding the P/E ratio from Brynjar Örn Ólafsson. The ratio is adjusted for inflation and is consequently real, but in a personal conversation with Brynjar he stated that the adjustment has no impact on the ratio itself, because the same adjustment is made to the price (numerator) and earnings (denominator). All the calculations on the MRP are done in nominal terms in the research, all other variables in the calculations on the risk premium factor are nominal, growth and risk-free rate.

One more thought on the P/E ratio is the fact that it is derived from the OMXI6/8PI index, that version of the index is not capped, so the weight of companies like Marel is extremely high within the index. In a personal conversation with Magnús Harðarson from Nasdaq

85 he confirmed that in the uncapped version of the index the weight of Marel has risen to over 50%.

Unfortunately, a P/E ratio for the capped version of the index is not available, but for further studies on the risk premium factor model I would recommend constructing a P/E ratio using the capped version of the index, to get a better estimation for the whole market. Also, keep the ratio in nominal terms for the sake of consistency.

The correlation between the inverse P/E ratio, the E/P ratio and the MRP is high, calculated at 0.86. In the figure below the relationship is presented and it can be seen that usually the MRP is below the E/P ratio, but a spike in the MRP puts it above the E/P ratio in the beginning of 2nd quarter of 2016.

For a perfect market the implied MRP can be calculated as the E/P ratio minus the risk- free rate. In that context it would be normal to assume that the MRP is lower than the E/P ratio, but like already covered the Icelandic market is far from being perfect, with literature suggesting that the market is inefficient.

Figure 12. Relationship between market risk premium and E/P ratio in the RPF model

Market risk premium E/P ratio

10.00%

8.00%

6.00%

4.00%

2.00%

0.00% 4/30/10 4/30/11 4/30/12 4/30/13 4/30/14 4/30/15 4/30/16 4/30/17 4/30/18

Source: Market Risk Premium calculated by the author based on data from: P/E from (Ólafsson, 2019). Growth from (The Central Bank of Iceland, 2019) and risk-free rate retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

The geometric average for the time period is 6.08%. Evidence from the interviews suggest that number is consistent with the MRP used by practitioners. When looking at the MRPs around the world, already covered in the research, 6.08% is not far off what is used in other mature markets. Further this estimate is based on data that can be described as statistically significant, with the standard error of the calculated MRP 2.38% for the whole time period.

The decline in the MRP in 2019 is interesting, it is consistent with the calculations using discounted cash flow estimation on dividend- and buyback yield where the implied premium was 3.73%. According to the risk premium factor model the average premium for the first quarter of 2019 is 3.03%. The contributing factors to a lower implied MRP are declining risk-free rate, lower growth expectation as well as a sharply declining E/P ratio.

The risk premium factor model aims to create a factor that can be used to predict what the MRP is by multiplying the factor to the risk-free rate. To create a risk premium factor based on data from the time period proved to be problematic. The volatility of the risk premium factor is too high. Additionally, Stephen Hassett does not provide detailed information on how he constructs the risk premium factor. In the figure below the monthly volatility of the risk premium factor can be seen for the research period.

Figure 13. Monthly volatility of the Risk Premium Factor

2.50

2.00

1.50

1.00

0.50

0.00 4/30/10 4/30/11 4/30/12 4/30/13 4/30/14 4/30/15 4/30/16 4/30/17 4/30/18

Source: Calculated by the author based on data from: P/E from (Ólafsson, 2019). Growth from (The Central Bank of Iceland, 2019) and risk-free rate retrieved via email from Nasdaq Iceland (personal communication, May 15, 2019).

To summarize: An MRP of 6.08% is within the range obtained from multiple foreign equity markets as well as what is currently being used in Iceland by valuation specialist and market analysts.

6.3 Conclusion on the Interviews For the research five interviews were conducted, out of the five interviews only 3 are reported in chapter 5.3 since the other two did not add much substance in terms of cost of equity estimation or the MRP. The biggest difference was in terms of the risk-free rate, with both the interviewees, not reported, opting for the OMXI10YNI index as a proxy for the risk-free rate. That is the same proxy that is used in the research.

All of the interviewees use the same method to estimate cost of equity, the CAPM model. Specific risk components related to the characteristics of the companies in question are then added on top of the result from the CAPM model. In the cost of equity estimation, the biggest difference between interviewees was their choice of including inflation expectations in the calculations or not.

The interviewees are very similar when it comes to finding a proxy for the risk-free rate, with all of them opting for either RIKB28 or RIKB31 for nominal calculations. RIKS30 was used when calculations are real.

The MRP used by market participants seems to be in the range of 5% to 6.7%. Implied premiums are preferred by the majority of interviewees and that is consistent with the results in this research.

Duff and Phelps increased their estimate for the MRP from 5% to 5.5% for 2019. Damodaran implied premium is 5.96% for 2019, and by adding the CDS spread on that premium an MRP of 6.58% is obtained. That range is consistent with the range estimated from the interviews.

There seems to be an interest among some of the interviewees to conduct a survey on the MRP. A survey among not only investors, but also market analysts, CFO´s and academics could bridge a gap when talking about MRP in Iceland.

Finally, there seems to be a harmony among the interviewees that the relationship between the MRP and the risk-free rate is not positive, with majority suggesting that the relationship is in fact negative.

Assuming that the risk-free rate declines in time of uncertainty the MRP would increase, that is consistent with the view presented in the introduction chapter, with the MRP increasing in bear markets and decreasing in bull markets.

6.4 Overall Conclusion on the Market Risk Premium in Iceland The MRP is a forward-looking concept and because it is a forward-looking concept, there are plenty of options available to get an estimate of the MRP. The availability and quality of data can be the determinant of what method is used to estimate the MRP. For a market like the Icelandic one, where there is strong evidence pointing to the inefficiency of the market, surveys on a large scale on the required MRP from investors, market analyst and CFO’s could serve as a good starting point in discussing the relevant MRP for the Icelandic market.

The evidence in this research is that the implied MRP in Iceland has been declining in 2019. That is contrary to the feeling market participants have, following a decline in the risk-free rate in 2019 they have seen the MRP increasing. Using mature foreign markets for a base premium and adding a country risk premium on top of that is an alternative method. By using that method, the practitioner can control the outcome to a certain extent by choosing a base premium that suites him/here as well as including or dismiss the volatility of equity markets. If the company in question has a foreign revenue stream, then the base premium should be from that market.

I would recommend the range for the MRP in Iceland should start with the MRP obtained from the implied risk premium factor model, 6.08%. This numbers are in the range of what is already used by market practitioners in Iceland. With earnings and the risk-free rate declining in the equity market, the market can be described as a bear market at the moment. The MRP should increase in that type of market conditions. With increased risk in the equity market the appropriate MRP could consequently be closer to the MRP obtained in the historical MRP (6.72%) calculations, despite the high standard error and the upper limit of the country risk premium (6.73%). The conclusion is that the MRP should be in the region of 6.08% to 6.73%.

Other methods should be used to validate this estimate. I would recommend studying the discounted cash flow model using dividend yield and buyback yield back to 2010 to get a better picture of the development of the implied MRP. Using dividend yield and buyback yield in valuation offers a different perspective from the earnings-based risk premium factor model. When estimating a forward-looking concept like the MRP it is vital to examine it from all angles.

To end the discussion about the MRP it is appropriate to quote Brealey, Myers and Allen: "Do not trust anyone who claims to know what returns investors expect. History contains some clues, but ultimately we have to judge whether investors on average have received what they expected.” (Brealey , Myers, & Allen, 2017).

The MRP is a variable that is evolving constantly. I would recommend that further studies are done on the subject.

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Ibbotson, G. R. (2011). The Equity Risk Premium. In P. B. Hammond Jr, M. L. Leibowitz, & L. B. Siegel, Rethinking the equity risk premium (pp. 18-26). Research Foundation of CFA institute. ICE Benchmark Administration Limited (IBA). (2019, August 15). ICE BofAML Public Sector Issuers Emerging Markets Corporate Plus Sub-Index Effective Yield [BAMLEMPBPUBSICRPIEY]. Retrieved from Federal Reserve Bank of St. Louis: https://fred.stlouisfed.org/series/BAMLEMPBPUBSICRPIEY Ilmanen, A. (2003). Expected Returns on Stocks and Bonds. The Journal of Portfolio Management 29, 7-27. Indro, D. C., & Lee, W. Y. (1997). Biases in Arithmetic and Geometric Averages as Estimates of Long-Run Expected Risk Premia. Financial Management, Vol. 26 No. 4, 81-90. Jónsdóttir, E., & Gústafsdóttir, S. E. (2019, May). Hver er þátttaka almennings á hlutabréfamarkði á Íslandi? Reykjavík: Reykjavík University. Jónsson, Á., & Gunnlaugsson, S. B. (2004). Umframávöxtun á Íslenskum hlutabréfamarkaði. Tímarit um viðskipti og efnahagsmál, 67-85. Kaserer, C., Willershausen, T., Berg, T., & Kittlauss, D. (2019, August 5). Market Risk Premia. Retrieved from Market-Risk-Premia.com Application of Valuation Parameters in Practice: http://www.market-risk-premia.com/market-risk- premia.html Koller, T., Goedhart, M., & Wessels, D. (2015). Valuation. Measuring and Managing the Value of Companies. New Jersey: Wiley. Lally, M., & Randal, J. (2015). Estimating the Market Risk Premium Using Data from Multiple Markets. Economic Record. Vol. 91, Issue 294, 324-337. Magnússon, G. (2016). Áhættuálag hlutabréfa í ljósi hrun markaða. Þjóðarspegillinn. Ráðstefna í félagsvísindum XVII (pp. 1-12). Reykjavík: Félagsvísindarstofnun Háskóla Íslands. Mbl. (2014, April 1). Félögum í Úrvalsvísitölunni fjölgar. Retrieved from mbl.is: https://www.mbl.is/vidskipti/frettir/2014/04/01/felogum_i_urvalsvisitolunni_fjol gar_2/ Mehra, R. (2006). The Equity Premium Puzzle: A Review. Fundations and Trends in Finance, Vol.2, no 1, 1-81. Mehra, R., & Prescott, E. C. (1985). The equity premium: A puzzle. Journal of Monetary Economics Vol. 15, 145-161.

Mixa, M. W., & Sigurjónsson, Þ. O. (2010). Áfram á rauðu ljósi - fjármálahrunið á Íslandi og reynsla Norðurlandanna. Tímarit um viðskipti og efnahagsmál, vol. 7, no.1, 21-37. Modigliani, F., & Miller, M. H. (1961). Dividend Policy, Growth, and the Valuation of Shares. Journal of Business. Vol. 34. No. 4, 411-433. Nasdaq. (2018, May). Rules for the Construction and Maintenance of the OMX Iceland 8 Index. Version 1.7. Retrieved from Nasdaq Global Indexes: https://indexes.nasdaqomx.com/docs/Methodology_OMXI8.pdf Nasdaq Iceland hf. (2011. February 2011). Skuldabréfavísitölur NASDAQ OMX Iceland . Retrieved from GlobeNewswire: https://www.globenewswire.com/news- release/2011/02/22/202318/0/is/N%C3%BD- skuldabr%C3%A9fav%C3%ADsitala-Kauphallarinnar-10-%C3%A1ra- %C3%B3ver%C3%B0trygg%C3%B0.html Nasdaq Iceland hf. (2018, March Version 2.4). Rules for the Construction and Maintenance of the NASDAQ OMX All-Share, Benchmark and Sector Indexes. Retrieved from NASDAQ Index Research and Resources: https://indexes.nasdaqomx.com/docs/Methodology_NORDIC.pdf Neely, C. J., Rapach, D., Tu, J., & Zhou, G. (2011, October 16). Forecasting the Equity Risk Premium: The Role of Technical Indicators. Electronic copy available at: http://ssrn.com/abstract=1787554. Pratt, S. P., & Grabowski, R. J. (2008). Cost of Capital. Applications and Examples. New Jersey: John Wiley & Sons, Inc. Reilly, R. K., & Brown, K. C. (2012). Investments Analysis & Portfolio Management. 10th edition. Mason, OH: South-Western Cenage Learning. Ritstjórn. (2011, February 28). Viðskiptablaðið. Retrieved from vb.is: https://www.vb.is/frettir/kauphollin-hefur-utreikning-nyrri- visitolu/61637/?q=%C3%8Dsland. Salomons, R., & Grootveld, H. (2002, August 7). The Equity Risk Premium: Emerging Versus Developed Markets. University of Groningen SOM Working Paper No. 02E45. Retrieved from SSRN: https://ssrn.com/abstract=535662 Sigurðsson, B. (2019, February 1). Markaðsálag á Íslandi. Þróun markaðsálags á aðalmarkaði Nasdaq OMX Ísland. Retrieved from skemman: https://skemman.is/bitstream/1946/32124/1/Marka%C3%B0s%C3%A1lag%20 %C3%A1%20%C3%8Dslandi%20-%20Benedikt%20Sigur%C3%B0sson.pdf

The Central Bank of Iceland . (2019, July 15). The Republic of Iceland's sovereign credit rating. Retrieved from cb.is: https://www.cb.is/about-the- bank/government-debt-management/the-republic-of-icelands-sovereign-credit- rating/ The Central Bank of Iceland. (2019, June 25). Rit og skýrslur. Peningamál. Retrieved from sedlabanki.is: https://www.sedlabanki.is/utgefid-efni/rit-og-skyrslur/rit-og- skyrslur-oll-ar/?all=1 THOMSON REUTERS EIKON 1). (2019). OMXI10 ISK GI INDEX. Retrieved from OMXI10GI PRICE HISTORY: https://emea1.apps.cp.thomsonreuters.com/web/Apps/Index/#/Apps/PriceHistor y THOMSON REUTERS EIKON 2). (2019). OMXI10 ISK PI INDEX. Retrieved from OMXI10 PRICE HISTORY: https://emea1.apps.cp.thomsonreuters.com/web/Apps/Index/#/Apps/PriceHistor y Viðskiptablaðið. (2019, June 14). VÍS og Sjóvá ný inn i vísitöluna. Retrieved from Viðskiptablaðið: https://www.vb.is/frettir/vis-og-sjova-ny-inn-i- visitoluna/155062/

Appendix 1 – The Annual Yield on the Proxy for the Risk-Free Rate

Year Yield Index name Ticker Issuer

2010 6,21% OMX Iceland 5 Year Non-Indexed OMXI5YNI Nasdaq Iceland hf

2011 7,21% OMX Iceland 10 Year Non-Indexed OMXI10YNI Nasdaq Iceland hf

2012 7,08% OMX Iceland 10 Year Non-Indexed OMXI10YNI Nasdaq Iceland hf

2013 6,63% OMX Iceland 10 Year Non-Indexed OMXI10YNI Nasdaq Iceland hf

2014 6,98% OMX Iceland 10 Year Non-Indexed OMXI10YNI Nasdaq Iceland hf

2015 6,42% OMX Iceland 10 Year Non-Indexed OMXI10YNI Nasdaq Iceland hf

2016 5,67% OMX Iceland 10 Year Non-Indexed OMXI10YNI Nasdaq Iceland hf

2017 4,92% OMX Iceland 10 Year Non-Indexed OMXI10YNI Nasdaq Iceland hf

2018 5,45% OMX Iceland 10 Year Non-Indexed OMXI10YNI Nasdaq Iceland hf

2019 5,18% OMX Iceland 10 Year Non-Indexed OMXI10YNI Nasdaq Iceland hf

Appendix 2- The Annual Returns on the OMXIGI and OMXIPI

OMXIGI OMIXPI

Year Price Return Price Return

2010 249,42 14,64% 569,19 14,65%

2011 255,54 2,45% 580,73 2,03%

2012 301,31 17,91% 678,15 16,78%

2013 388,85 29,05% 864,93 27,54%

2014 437,03 12,39% 956,44 10,58%

2015 621,71 42,26% 1319,96 38,01%

2016 592,32 -4,73% 1232,09 -6,66%

2017 629,24 6,23% 1289,95 4,70%

2018 611,5 -2,82% 1217,58 -5,61%

1st quarter of 2019 758,91 24,11% 1474,33 21,09%

Appendix 3 – Nasdaq Price Return Index Calculation

The information is taken directly from Rules for the Construction and Maintenance of the NASDAQ OMX All-Share, Benchmark and Sector Indexes. The Price Return (PR) Index Value reflects changes in market value of Index Shares during the trading day. The PR Index is calculated without regard to ordinary dividends. The formula is as follows: �� = �� Where: �� = Price Return Index Value at time (t) �� = ��, � ∗ ��, � ∗ ��, � where; ��,� = Number of shares (i) applied in the Index at time (t) ��,� = Price in quote currency of a security (i) at time (t) ��,� = Foreign exchange rate to convert Index Share (i) quote currency into Index currency at time (t) The Divisor serves the purpose of scaling an Index Market Value to lower order of magnitude, which is recommended for reporting purposes. The Divisor is adjusted to ensure that changes in Index Shares either by corporate actions or index participation occurring outside of trading hours do not affect the value of the Index. A divisor change occurs after the close of Index the Index. The PR Divisor for day (t) is calculated as the ratio of the Start Of Day (SOD) Market Value and the previous day’s Index Value as follows: �� = �� − 1 Where: �� −1 = Price Return Index Value at time (t-1) �� = �� ∗ �� ∗ ��, � − 1 where; ��= Number of shares (i) applied in the Index, adjusted to reflect corporate actions if any �� = Price in quote currency of a security (i), adjusted to reflect corporate actions if any ��,�−1 = Foreign exchange rate to convert Index Share (i) quote currency into Index currency at time (t-1)

Appendix 4 - Nasdaq Gross Total Return Index Calculation

The Gross Total Return (GTR) Index Value reflects changes in market value of Index Shares during the trading day. There are two calculation methods for the GTR Index: (1) The GTR Index with linkage (same Index Divisor) to a corresponding PR Index; and (2) The GTR Index with no linkage to a corresponding PR Index. See Appendix B for the list of calculation methods. The formula is as follows: �� + �� = �� − 1� �� − 1 Where: �� = Gross Total Return Index Value at time (t) �� −1= Gross Total Return Index Value at time (t-1) �� = Price Return Index Value at time (t) �� −1= Price Return Index Value at time (t-1) �� (�� ) = �� Where: �� = ��, � ∗ ��, � ∗ ��, � − 1 where; ��,� = Number of shares (i) applied in the Index at time (t) ��,� = Ordinary dividend in the index at time (t) ��,�−1 = Foreign exchange rate to convert Index Share (i) quote currency into Index currency at time (t-1)

For the GTR Index with no linkage to a corresponding PR Index, the Divisor is calculated as follows: �� = �� − 1 Where: �� = �� ∗ �� ∗ ��, � − 1 where; ��= Number of shares (i) applied in the Index, adjusted to reflect corporate actions if any �� = Price in quote currency of a security (i), adjusted to reflect corporate actions if any ��,�−1 = Foreign exchange rate to convert Index Share (i) quote currency into Index currency at time (t-1) �� −1 is provided in Index File Report Products.

100

Appendix 5 - Companies in the OMXI6/8 Index from January 2010

07 01 02 01 02 01 02 01 02 01 * 02 01 02 01 07 01 07 01 01 ------2019 2018 2018 2017 2017 2016 2016 2015 2015 2014 2014 2013 2013 2012 2012 2010 Ticker Company 2011 2011 2010

MARL Marel hf. x x x x x x x x x x x x x x x x x x x

OSSRu Össur hf. x x x x x x x

BNORDIK BankNordik P/F x x x x x x

BAKK Bakkavör Group hf. x1

FO-ATLA P/F Atlantic Petroleum x x x x x

FO-AIR Atlantic Airways P/F x x x2 x

ICEAIR Icelandair Group hf. x x x x x x x x x x x x x x x x x x x1

FO-EIK Eik Banki P/F x2

HAGA Hagar hf. x x x x x x x x x x x x x x

REGINN Reginn hf. x x x x

EIM Eimskipafélag Íslands hf. x x x x x x x x x

TM Tryggingamiðstöðin hf x x x x

VIS Vátryggingafélag Íslands hf. x x x x x x

GRND HB Grandi hf. x x x x x

FESTI Festi hf.** x x x x x x x x x x

SJOVA Sjóvá-Almennar tryggingar hf. x

REITIR Reitir fasteignafélag x x x x x x x x

SIMINN Síminn hf. x x x x x x x

EIK Eik fasteignafélag x x x x x

SKEL Skeljungur hf. x

X1 – Bakk stock excluded from the index on April 16, 2010 and ICEAIR stock included in the index the following day.

X2 – FO-EIK stock excluded from the index on October 19, 2010 and FO-AIR included in the index the following day.

*The constituents in the index increased from 6 to 8 companies.

**Previously known as N1 hf. the name changed to Festi hf. at September 25, 2018.

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Appendix 6 – The Interview Guide

1. What model do you use in your cost of equity estimations? a) Pros and cons? b) Do you make any adjustments? c) Do you use the same model for the Icelandic market and foreign markets? d) Is your estimate on nominal- or real terms? 2. What is your proxy for the risk-free rate? a) Maturity time? b) Foreign or domestic? c) Index or a government bond? 3. What is your market risk premium for the Icelandic market? a) Do you think that that is a fair number for the Icelandic market? b) When was the last time that you changed your estimate? c) Has the market risk premium increased or decreased from your last estimate? 4. Is your market risk premium estimate based on historical returns? a) If yes, then: i. What is your benchmark for market returns? ii. What time period are you using? iii. Is the risk-free rate the same as in the cost of equity estimation? iv. Do you use geometric or arithmetic average of returns? 5. Is your market risk premium estimate based on implied premium? a) If yes, then: i. What model is used in the calculations? ii. Does the model require an index, if yes what index do you use? iii. Is the risk-free rate the same as in cost of equity estimation? iv. How often do you estimate the implied premium? 1. Monthly? 2. Quarterly? 3. Annually? 6. Is your market risk premium estimate based on surveys? a) If yes, then: i. Who are the surveys participants? 1. Academics 2. Market analysts 3. Investors 4. Other? 102

ii. How often is the survey conducted? 1. Monthly? 2. Quarterly? 3. Annually?

7. Bonus question: In your opinion do you think that there is a link between the risk-free rate and the MRP in a way that, when RF increases the MRP does to and vice versa?

103

104