A New 'Risky' World Order: Unstable Risk Premiums: Implications for Practice
64 Pages Posted: 1 Sep 2010 Last revised: 6 Sep 2010
Date Written: August 23, 2010
Investors have to be offered risk premiums to invest in risky assets. These risk premiums take different forms in different asset markets: equity risk premiums (ERP) in stock markets, default spreads in bond markets and real asset premiums in other asset markets. These premiums have their roots in fundamentals and will vary as a function of uncertainty about the economy, the risk aversion of investors, information uncertainty and fear of catastrophe, among other factors. In practice, analysts in developed markets have generally looked backwards to estimate risk premiums, using historical data to arrive at their estimates. Implicitly, they assume that historical averages are not only precise but also that risk premiums are stable and revert back quickly to historical norms. In this paper, we present evidence that risk premiums in equity, bond and real asset markets are not only imprecise, but are also unstable and linked across markets. We present estimation approaches that are more in line with dynamic, shifting risk premiums. We argue that the resulting estimates can help use make more informed asset allocation and asset valuation judgments in portfolio management and better investment, financing and dividend decisions in corporate finance.
Keywords: Equity Risk Premiums, Default Spreads, Risk Premiums, Cost of Capital, Valuation
JEL Classification: G11, G12, G31, G32
Suggested Citation: Suggested Citation