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A New 'Risky' World Order: Unstable Risk Premiums: Implications for Practice

Aswath Damodaran

New York University - Stern School of Business

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.

Number of Pages in PDF File: 64

Keywords: Equity Risk Premiums, Default Spreads, Risk Premiums, Cost of Capital, Valuation

JEL Classification: G11, G12, G31, G32

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Date posted: September 1, 2010 ; Last revised: September 6, 2010

Suggested Citation

Damodaran, Aswath, A New 'Risky' World Order: Unstable Risk Premiums: Implications for Practice (August 23, 2010). Available at SSRN: https://ssrn.com/abstract=1669398 or http://dx.doi.org/10.2139/ssrn.1669398

Contact Information

Aswath Damodaran (Contact Author)
New York University - Stern School of Business ( email )
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0340 (Phone)
212-995-4233 (Fax)
HOME PAGE: http://www.damodaran.com
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