• The expected risk premium measures the extra return that would be demanded by investors for shifting their money from a riskless investment to an average- risk investment
  • In the CAPM, the premium is computed to be the difference between average returns on stocks and average returns on risk-less securities over an extended period of history
  • We use the geometric average premium earned by stocks over Treasury bonds between maximum possible time periods 
  • We choose the long time period to reduce standard error, the Treasury bond to be consistent with our choice of a risk-free rate, and geometric averages to reflect our desire for a risk premium that we can use for longer-term expected returns
Country Risk Premiums

To estimate the risk premium in emerging markets, we will use:

Equity risk premium = Base premium for mature equity market + Country premium
  • We will use the US equity market as a mature market
Approached to estimate the country risk premium:
  • Country bond default spreads - Indian Government Bonds (maturity in 2028) rating by Moody's: Ba2
India Sovereign rating by S&P: BBB+
India government 10-year bond yield: 7.78%
Interest rate: 3.25%

India is rated Ba2 in 2009 by Moody's, and the 10-year Indian government bond was priced to yield  7.78% in February 2010, 4.53% more than the interest rate (4.25%) on a 10-year Treasury bond at the same time. If we assume that the total equity risk premium for the United states and other mature equity markets is 4.29% (which was the historical premium through the end of 2009), the risk premium for India would be 8.82%                                                                          
  • Relative standard deviations - A conventional measure of equity risk is the standard deviation in stock prices; higher standard deviations are generally associated with more risk. 

Both the US and Indian standard deviations were computed using weekly returns for two years from the beginning of 2008 to the end of 2009. The annual standard deviation of Dow Jones Industrial Average is 3.6%. The annualized standard deviation in the SENSEX index was 7.15%, yielding a relative standard deviation of 1.98

 Thus, Equity Risk Premium (India) = 4.29% * 1.98 = 8.52%

  • Default spreads plus relative standard deviations - In this approach we look at the volatility of the equity market in a country relative to the volatility of the country bond used to estimate the spread.

Implied Equity Premiums

  • This methodology assumes that the overall stock market is correctly priced and uses a very simple valuation model for stocks
  • The implied equity premiums change over time much more than historical risk premiums and seldom been as high as the historical risk premium
  • When analysts are asked to value companies without taking a point of view on the overall market, they should be using the current implied equity risk premium

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