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Risk Tests

Risk Tests. Historical Premiums. The historical risk premium is the difference between the realized annual return from investing in stocks and the realized annual return from investing in a riskless security (T. Bill, T. Bond) over a past time period.

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Risk Tests

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  1. Risk Tests

  2. Historical Premiums • The historical risk premium is the difference between the realized annual return from investing in stocks and the realized annual return from investing in a riskless security (T. Bill, T. Bond) over a past time period. • To estimate this risk premium, how long a time period should you use? • Just one year (last year) • Last 5 years (to reflect current conditions) • As long a time period as you can get the historical data for • Should match the time period on your riskfree rate • Should match the time period used to estimate your beta • Assume that 2011 turns out to be a terrible year for stocks. If that occurs, you should expect to see the historical risk premium next year (including 2011): • Go up • Go down

  3. Forward Looking Premiums • Assume that you were looking at an investment, where you were guaranteed a cash flow of $ 1 (with certainty) every year in perpetuity. How much would you pay for this investment right now? • Now assume that you were looking at an investment, where you expect to generate a cash flow of $ 1, with about the same uncertainty as you would face on an average risk stock, in perpetuity. How much would you pay for this investment?

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