Managing And Measuring Of Risk: Emerging Global Standards And Regulations After The Financial Crisis

Emerging Global Standards and Regulations After the Financial Crisis

Oliviero Roggi, Edward I Altman

• Publisher: WSPC
• Year: 2013
• ISBN:
  9789814417518
• Topic: Biological Sciences
• Subtopic: Science General
• Index: Biological Sciences

This edited volume presents the most recent achievements in risk measurement and management, as well as regulation of the financial industry, with contributions from prominent scholars and practitioners such as Robert Engle, 2003 Nobel Laureate in Economics, Viral Acharya, Torben Andersen, Zvi Bodie, Menachem Brenner, Aswath Damodaran, Marti Subrahmanyam, William Ziemba and others. The book provides a comprehensive overview of recent emerging standards in risk management from an interdisciplinary perspective. Individual chapters expound on the theme of standards setting in this era of financial crises where new and unseen global risks have emerged. They are organized in a such a way that allows the reader a broad perspective of the new emerging standards in macro, systemic and sovereign risk before zooming into the micro perspective of how risk is conceived and treated within a corporation. A section is dedicated to credit risk and to the increased importance of liquidity both in financial systems and at the firm's level.

Contents:

• The Evolution of Risk Management:
  • An Evolutionary Perspective on the Concept of Risk, Uncertainty and Risk Management (Oliviero Roggi and Omar Ottonelli)
• Sovereign and Systemic Risk:
  • Toward A Bottom-Up Approach to Assessing Sovereign Default Risk: An Update (Edward I Altman and Herbert Rijken)
  • Measuring Systemic Risk (Viral V Acharya, Christian Brownlees, Robert Engle, Farhang Farazmand and Matthew Richardson)
  • Taxing Systemic Risk (Viral V Acharya, Lasse Pedersen, Thomas Philippon and Matthew Richardson)
• Liquidity:
  • Liquidity and Efficiency in Three Related Foreign Exchange Options Markets (Menachem Brenner and Ben Z Schreiber)
  • Illiquidity or Credit Deterioration: A Study of Liquidity in the US Corporate Bond Market During Financial Crises (Nils Friewald, Rainer Jankowitsch and Marti G Subrahmanyam)
• Risk Management Principles and Strategies:
  • Integrated Wealth and Risk Management: First Principles (Zvi Bodie)
  • Analyzing the Impact of Effective Risk Management: Innovation and Capital Structure Effects (Torben Juul Andersen)
• Credit Risk:
  • Modeling Credit Risk for SMEs: Evidence from the US Market (Edward I Altman and Gabriele Sabato)
  • SME Rating: Risk Globally, Measure Locally (Oliviero Roggi and Alessandro Giannozzi)
  • Credit Loss and Systematic LGD (Jon Frye and Michael Jacobs Jr.)
• Equity Risk and Market Crashes:
  • Equity Risk Premiums (ERP): Determinants, Estimation and Implications — The 2012 Edition (Aswath Damodaran)
  • Stock Market Crashes in 2007–2009: Were We Able to Predict Them? (Sébastien Lleo and William T Ziemba)

Readership: Researchers and professionals with interest in risk management within the context of the banking, econometrics, mathematical economics, quantitative finance, corporate and risk governance, and corporate finance.

Chapter 12

EQUITY RISK PREMIUMS (ERP): DETERMINANTS,
ESTIMATION AND IMPLICATIONS — THE
2012 EDITION^∗

Aswath Damodaran

Stern School of Business, USA

Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. We begin this chapter by looking at the economic determinants of equity risk premiums, including investor risk aversion, information uncertainty and perceptions of macroeconomic risk. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and volatile. We look at two other approaches to estimating equity risk premiums — the survey approach, where investors and managers are asked to assess the risk premium and the implied approach, where a forward-looking estimate of the premium is estimated using either current equity prices or risk premiums in

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^∗ This is the fifth update of this piece. The first update was in the midst of the banking crisis in 2008 and there were annual updates for 2009, 2010 and 2011.

non-equity markets. We also look at the relationship between the equity risk premium and risk premiums in the bond market (default spreads) and in real estate (cap rates) and how that relationship can be mined to generated expected equity risk premiums. We close the chapter by examining why different approaches yield different values for the equity risk premium, and how to choose the “right” number to use in analysis.

The notion that risk matters, and that riskier investments should have higher expected returns than safer investments, to be considered good investments, is intuitive and is central to risk and return models in finance. Thus, the expected return on any investment can be written as the sum of the riskfree rate and a risk premium to compensate for the risk. The disagreement, in both theoretical and practical terms, remains on how to measure the risk in an investment, and how to convert the risk measure into an expected return that compensates for risk. A central number in this debate is the premium that investors demand for investing in the ‘average risk’ equity investment (or for investing in equities as a class), i.e., the equity risk premium.

In this chapter, we begin by examining competing risk and return models in finance and the role played by equity risk premiums in each of them. We argue that equity risk premiums are central components in every one of these models and consider what the determinants of these premiums might be. We follow up by looking at three approaches for estimating the equity risk premium in practice. The first is to survey investors or managers with the intent of finding out what they require as a premium for investing in equity as a class, relative to the riskfree rate. The second is to look at the premiums earned historically by investing in stocks, as opposed to riskfree investments. The third is to back out an equity risk premium from market prices today. We consider the pluses and minuses of each approach and how to choose between the very different numbers that may emerge from these approaches.

Equity Risk Premiums: Importance and Determinants

Since the equity risk premium is a key component of every valuation, we should begin by looking at not only why it matters in the first place but also the factors that influence its level at any point in time and why that level changes over time. In this section, we look at the role played by equity risk premiums in corporate financial analysis, valuation and portfolio management, and then consider the determinants of equity risk premiums.

Why Does the Equity Risk Premium Matter?

The equity risk premium reflects fundamental judgments we make about how much risk we see in an economy/market and what price we attach to that risk. In the process, it affects the expected return on every risky investment and the value that we estimate for that investment. Consequently, it makes a difference in both how we allocate wealth across different asset classes and which specific assets or securities we invest in within each asset class.

A price for risk

To illustrate why the equity risk premium is the price attached to risk, consider an alternate (though unrealistic) world where investors are risk neutral. In this world, the value of an asset would be the present value of expected cash flows, discounted back at a risk free rate. The expected cash flows would capture the cash flows under all possible scenarios (good and bad) and there would be no risk adjustment needed. In the real world, investors are risk averse and will pay a lower price for risky cash flows than for riskless cash flows, with the same expected value. How much lower? That is where equity risk premiums come into play. In effect, the equity risk premium is the premium that investors demand for the average risk investment, and by extension, the discount that they apply to expected cash flows with average risk. When equity risk premiums rise, investors are charging a higher price for risk and will therefore pay lower prices for the same set of risky expected cash flows.

Expected returns and discount rates

Building on the theme that the equity risk premium is the price for taking risk, it is a key component into the expected return that we demand for a risky investment. This expected return, is a determinant of both the cost of equity and the cost of capital, essential inputs into corporate financial analysis and valuation.

While there are several competing risk and return models in finance, they all share some common assumptions about risk. First, they all define risk in terms of variance in actual returns around an expected return; thus, an investment is riskless when actual returns are always equal to the expected return. Second, they argue that risk has to be measured from the perspective of the marginal investor in an asset, and that this marginal investor is well diversified. Therefore, the argument goes, it is only the risk that an investment adds on to a diversified portfolio that should be measured and compensated. In fact, it is this view of risk that leads us to break the risk in any investment into two components. There is a firm-specific component that measures risk that relates only to that investment or to a few investments like it, and a market component that contains risk that affects a large subset or all investments. It is the latter risk that is not diversifiable and should be rewarded.

All risk and return models agree on this fairly crucial distinction, but they part ways when it comes to how to measure this market risk. In the capital asset pricing model (CAPM), the market risk is measured with a beta, which when multiplied by the equity risk premium yields the total risk premium for a risky asset. In the competing models, such as the arbitrage pricing and multi-factor models, betas are estimated against individual market risk factors, and each factor has it own price (risk premium). Table 1 summarizes four models, and the role that equity risk premiums play in each one:

All of the models other than proxy models require three inputs. The first is the riskfree rate, simple to estimate in currencies where a default free

Table 1 : Equity Risk Premiums in Risk and Return Models.

entity exists, but more complicated in markets where there are no default free entities. The second is the beta (in the CAPM) or betas (in the APM or multi-factor models) of the investment being analyzed, and the third is the appropriate risk premium for the portfolio of all risky assets (in the CAPM) and the factor risk premiums for the market risk factors in the APM and multi-factor models. While I examine the issues of riskfree rate and beta estimation in companion pieces, I will concentrate on the measurement of the risk premium in this chapter.

Note that the equity risk premium in all of these models is a market-wide number, in the sense that it is not company specific or asset specific but affects expected returns on all risky investments. Using a larger equity risk premium will increase the expected returns for all risky investments, and by extension, reduce their value. Consequently, the choice of an equity risk premium may have much larger consequences for value than firm-specific inputs such as cashflows, growth and even firm-specific risk measures (such as betas).

Investment and policy implications

It may be tempting for those not in the midst of valuation or corporate finance analysis to pay little heed to the debate about equity risk premium, but it would be a mistake to do so, since its effects are far reaching.

• The amounts set aside by both corporations and governments to meet future pension fund and health care obligations are determined by their expectations of returns from investing in equity markets, i.e., their views on the equity risk premium. Assuming that the equity risk premium is 6% will lead to far less being set aside each year to cover future obligations than assuming a premium of 4%. If the actual premium delivered by equity markets is only 2%, the fund's assets will be insufficient to meet its liabilities, leading to fund shortfalls which have to be met by raising taxes (for governments) or reducing profits (for corporations) In some cases, the pension benefits can be put at risk, if plan administrators use unre-alistically high equity risk premiums, and set aside too little each year.

• Business investments in new assets and capacity is determined by whether the businesses think they can generate higher returns on those investments than the cost that they attach to the capital in that investment. If equity risk premiums increase, the cost of equity and capital will have to increase with them, leading to less overall investment in the economy and lower economic growth.

• Regulated monopolies, such as utility companies, are often restricted in terms of the prices that they charge for their products and services. The regulatory commissions that determine “reasonable” prices base them on the assumption that these companies have to earn a fair rate of return for their equity investors. To come up with this fair rate of return, they need estimates of equity risk premiums; using higher equity risk premiums will translate into higher prices for the customers in these companies.¹

• Judgments about how much you should save for your retirement or health care and where you should invest your savings are clearly affected by how much return you think you can make on your investments. Being over optimistic about equity risk premiums will lead you to save too little to meet future needs and to over investment in risky asset classes.

Thus, the debate about equity risk premiums has implications for almost every aspect of our lives.

What are the Determinants of Equity Risk Premiums?

Before we consider different approaches for estimating equity risk premiums, we should exami...

Table of contents

• Cover
• Half Title
• contents
• Title
• Copyright
• Foreword
• About the Editors
• contents
• Part A
• Chapter 01
• Part B
• Chapter 02
• Chapter 03
• Chapter 04
• Part C
• Chapter 05
• Chapter 06
• Part D
• Chapter 07
• Chapter 08
• Part E
• Chapter 09
• Chapter 10
• Chapter 11
• Part F
• Chapter 12
• Chapter 13
• ABOUT THE RISK, BANKING AND FINANCE SOCIETY
• ABOUT THE INTERNATIONAL RISK MANAGEMENT CONFERENCE