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The Market Risk Premium: Expectational Estimates Using Analysts' Forecasts

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The Market Risk Premium: Expectational Estimates Using Analysts' Forecasts The Market Risk Premium: Expectational Estimates Using Analysts' Forecasts Robert S. Harris and Felicia C. Marston Us ing expectatwnal data from f711a11cial a 11 a~r.11s. we e~ t ima t e a market risk premium for US stocks. Using the S&P 500 a.1 a pro1·1•.fin· the market portfolio. the Lll'erage market risk premium i.lfound to be 7. 14% abo1·e yields on /o11g-ter111 US go1·ern 111 e11t honds m·er the period I 982-l 99X. This ri~k premium 1•aries over time; much oft his 1·aria1io11 can he explained by either I he /e1 1el ofi11teres1 mies or readily availahle fonrard-looking proxies for ri.~k . Th e marke1 ri.1k p remium appears to 111 onz inversely with gol'ern111 e11 t interes1 ra/es .rngges1i11g Iha/ required rerurns 011 .~locks are more stable than interest rates themse!Pes. {JEL: GJI. G l 2] Sfhc notion of a market ri sk premium (th e spread choice has some appealing chara cteri sti cs but is between in vestor required returns on safe and average subject to many arb itrary assumptions such as the ri sk assets) has long played a central rol e in finance. 11 releva nt period for tak in g an average. Compound ing is a key factor in asset allocation decisions to determine the difficulty or usi ng historical returns is the we ll the portfolio mi x of debt and equity instruments. noted fa ct that stand ard model s or consum er choice Moreover, the market ri sk premium plays a critica l ro le would predi ct much lower spreads between equity and in th e Capital Asset Pricing Model (CAPM ), the most debt returns than have occurred in US markets- the widely used means of estimating equity hurdle rates by so ca lled equity risk premium puzzle (sec Welch, 2000 practitioners. In recent years, the practical signifi ca nce and Siegel and Thaler, 1997). ln addition. theory call s of estimating such a market premium has increased as fo r a forward-l ook in g risk pre mium th at could well firms, financi al analysts. and in vestors empl oy fin ancial change over time. fram eworks to analyze corporate and in vestment This paper takes an alternate approach by usin g pe rform ance. For in s tance. th e increased use of expectational data to estimate the market risk premium. Economi c Value Added (EVA') to assess corp orate The a pproach has two major advantages for prac titioners. First, it provides a n independ ent performance has provided a new impetus for estimating estimate that can be compared to historical averages. capital costs. Al a minimum. this can help in understanding likely The most prevalent approach to estimating the market ranges for risk premi a. ccond, expectati onal data al low ri sk premium relies on some average of the historical in vestigation of changes in risk premia over time. uch spread between returns on stocks and bonds. 1 This time variations in risk premia serve as important signal s from investors th at should affect a host of financia l ·Robcn S. lla rr i ~ is 1he C. Ste\\ an Sheppard Professor of Business decisions. Th is paper provides new te ts of whether Administration and l·chcia C. Ma rston 1, an Associate l'mfcs,or changes in ri k premia over time are li nked 10 forward­ a1 1hc Uni' crsi1y of Vi rg in ia. Charlo1tcsv11lc. VA 22906. looking measures of ri sk. Specifica ll y, we look at the The a uthors tha nk Eri k Bcnrud. a n ano nymous re\ icwcr. and ,cmin a r participants a l the Universi ty or Vi rgi n ia. th e 113 run.:r. Ea des. Ha rris. a nd Higgins ( 1998) pro1 idc suncy University of Con nec tic ut and a 1 the SEC for co m ment~. c1 idene.: on hoth te\thuo1' advice and prac11110ncr 111c1hods T ha n!..;, to Darden Sponsors. TVA. the Walker Family Fund, for es11n1:11111g c.:a1lital eos1s. As tcs1:1n11.:n1 10 1hc market for and Mcintire A~'ociatco, for sup port t•I' this research and 10 cost of c;1p11al estimmc'. lbho1,on Assm:1a1cs ( 1998) publishes IBF.S, Inc. fo r s upplying data. a "( 0,1 of Capital Quarterly.'' 6 OPC 002716 FPL RC-16 HARRIS & MARSTON-THE MARKET RISK PREMIUM 7 relationship between the risk premium and four ex­ et al. ( 1998) point out, few respondents cited use of ante measures of ri sk: the spread between yields on expectational data to supplement or replace hi storical corporate and government bonds, consumer sentiment ret urns in estimating the market premium. about future economic conditions, the average leve l Survey evidence also shows substantial variation or dispersion across analysts as they forecast in empirical es tim ates. When respondents gave a corporate earnings. and the implied volatility on the precise estimate of th e market premium, they cited S& P500 In dex derived from options data. figures from 4% to over 7% (Bruner et al., 1998). A Section I provides background on the estimation of quote from a survey respondent highl ights the range equity required returns and a brief di sc ussion of in practice. " In 1993, we polled various investment current practice in estimating the market ri sk premium. banks and academic studies on the issue as to th e In Section II , models and data are discussed. Following appropriate rate and got anywhere between 2 and 8%, a comparison of the results to historical returns in but mos t we re between 6% and 7.4%." (Bruner et al.. Secti on 111. we examine the time-series characteristics I 998 ). An informal sampling of current practice also of the estimated market premium in Section IV. Finally, reveals la rge differences in assumptions about an conclusions are offered in Section V. appropriate market premium. For instance, in a 1999 application o f EVA analysis, Goldman Sachs I. Background In vestment Research specifics a market risk premium of"3% from 1994-1997 and 3.5% from I 998- l 999E for The notion of a ··market" required rate of return is a the S&P lndustrials" (Goldman Sachs, 1999). At the conveni ent and widely used construct. Such a rate (k) same time, an April 1999 phone call to Stern Stewart is the minimum level of expected return necessary to re vea led that their own applicati on of EVA typically compensate investors for bearing the average risk of employed a market risk premium of6%. In its application equity investments and receiving dollars in the future of the CAPM. Ibbotson Associates ( 1998) uses a market rather than in the present. In general. k wi ll depend on risk premium of7.8%. Nol surprisingly, academics do not returns available on a lternative investments (e.g., agree on the ri sk premium either. Welch (2000) surveyed bonds). To isolate the effects of ri sk, it is useful to leadin g financial economists at major universiti es. For a work in terms of a market risk premium (rp), defined as J O-year horizon, he found a mean ri sk premium of 7. I% but a range from 1.5% to 15% with an interquartile range Ip = k - i, ( I ) of2.4% (based on 226 responses). To provide additional insight on estimates of the where i = required return fo r a zero ri sk in ve tment. market premium , we use publicly avail able Lacking a superior alternati ve, in vestigators often expectational data. This expectational approach use averages of hi storical reali za tio ns to estimate a employs the di vidend growth model (hereafter referred market risk premium. Bruner. Eades. Harris, and Higgins to as the discounted cash now (DCF) model) in which ( 1998) provide recent_s urvey results on best practices a consensus measure of financial analysts' forecasts by corporati ons and financial advisors. While almost (FAF) of earnings is used as a proxy for in vestor all respondents used some average of past data in expectations. Earlier work has used FAF in DCF mode l s ~ estimatinu a market risk premium. a wide range of but generall y has covered a span of only a few years approaches emerged. "While most of our 27 sample due to data avai la bi lity. compan ies appear to use a 60+ year hi stori cal peri od to estimate returns, one cited a window of less than II. Models and Data ten years, two cited windows of about ten years, one began averaging with 1960, and another with 1952 data" The simplest and most commonl y used version of (p. 22). Some used arithmetic averages. and some used the DCF model is employed to estimate shareholders' geometric. Thi s hi stori cal approach requires the required rate of return, k, as shown in Equation (2): assumptions that past reali zati ons are a good surrogate for future expectations and, as typically app li ed. that th e risk premium is constant over tim e. Carl eton and :sec Malkicl ( 1982), Orighum, V in ~o n. an d Shorn.: ( 1985), Lakoni shok ( 1985) demonstrate empirica lly some of the Harris ( 1986), a nd Ha rris and Ma rston ( 1992). The DCF problems wit h such historical premia when th ey are approach w ith analysis· forecasts has been used frequently in disaggregated fo r different time periods or groups of reg ulator) settings.
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