1 / 21

Where A Risk Premium Exists

Where A Risk Premium Exists. Eric Falkenstein. Nature of Risk Exposed. From Super Safe to Safe Not from Safe to Insanely Risky Return Discount for Cash No alpha possible. AAA-BBB Spread. Moody’s data back to 1919 Return assuming 10 year bonds Can’t arbitrage: Can’t borrow at AAA rate

dory
Télécharger la présentation

Where A Risk Premium Exists

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Where A Risk Premium Exists Eric Falkenstein

  2. Nature of Risk Exposed • From Super Safe to Safe • Not from Safe to Insanely Risky • Return Discount for Cash • No alpha possible

  3. AAA-BBB Spread • Moody’s data back to 1919 • Return assuming 10 year bonds • Can’t arbitrage: Can’t borrow at AAA rate • But, makes ‘sense’ in standard theory (if too much)

  4. If only this worked in more places…

  5. …like the rest of the Corporate curve

  6. Yield Curve – why buy 30yr bonds?

  7. What is the Equity Risk Premium? • The most important constant in finance

  8. Equity Premium Evolution • Mehra and Prescott (1986): 6.2% • 1999 Barclays and CSFB estimated 8.8% • Ibbotson (1926-97): 8.9% • Finance Texts (1998): 8.5% • Ivo Welch Survey (1998): 8.5% Crash! • AIMR estimate (2002): 3.0% • WSJ survey (2005): 2.0% • CFO Magazine (2005): 5% • Ivo Welch (2009): 2%-4% at most 1%-8%

  9. Some adjustments • Initial used T-bills instead of T-bonds • Arithmetic vs. Geometric averages

  10. People ignore costs all the time • Net cost of Vegas? • Beardstown Ladies investment club • 1983-94 return 23.4% • Best selling authors • Audited financials: 9.1%, below 14.9% for market • Failed to include contributions

  11. Geometric vs. Arithmetic Averages • 1 to 2 to 1 has a total return of 0% • 100%, -50% return has average of -25% • Arithmetic returns useful if you rebalance, as opposed to invest all your money at inception • Stock returns have volatility around 20%, for the indices, which implied a 2%

  12. Post WW2 Price-Earning/Div Yield Decline • US Dividend yield went from 7.43% in 1872-1950, to 2.55% from 1951 to 2000 • Fama-French (2002): about 4% of Post WW2 return from this effect • Ret=div+cap gain • If div rate goes down, one time cap gain

  13. Bad Market Timing • Dichev (2005) • 1, 2, 1 •  return 0% if cf is {-1,0,+1} •  return -17.7% if cf is {-1,-1,+1.5} • Total return different than Internal Rate of Return based on timing of investments • Distributions  Dividends-New Money • Corr(Distributionst,Returnt+1)= +33% • Corr(Distributionst+1,Returnt)= -27% •  bad timing

  14. Bad Market Timing • 1.3% premium for buy-and-hold and IRR for NYSE/AMEX 1926-2002 • 5.3% for Nasdaq 1973-2002 • 1.5% for 19 major international stock exchanges 1973-2004

  15. Transaction Costs • Commissions, • 8.5% load through 1970’s to buy a mutual fund • bid-ask cross • Stocks quoted at 8 ¾ - 9 in the 1990s • buy at 9, sell at 8 ¾, lose 2.78% • Phantom cost: most investors don’t know real time prices • Stoll and Whaley (1983) 1.78% comm+bid-ask • Bhardwaj and Brooks (1992): 4.4% total • Currently very low if you are smart (0.2%)

  16. Transaction Costs-Market Impact • No good data, proprietary • I have data from a dead Hedge Fund, so its not proprietary (ie, Deephaven) • Look at fill price, vs price at open • Generally, 0.2% using sophisticated algorithms on liquid stocks when putting on $100k • Around 1-5% when putting on 1-10% of Avg. Daily Volume

  17. Survivorship Bias • USA primary data point in World Value Weighted Index • Coincidentally, • 2-0 in World Wars • Communist Party not popular • Brown, Goetzmann, and Ross (1995) • Czechoslovakia, Hungary, Poland, Russia, and China all zeroed out • Jorion and Goetzmann (1999) • US real return 350 basis points above median for 39 countries in 20th century

  18. Peso Problem • Peso-Dollar FX rate fixed from 1954-76 • Higher interest rate in Peso • Peso ‘floated’ in 1976: lost 45% • Peso devalued by 82% in 1982 • Small probability, big loss, explains interest rate premium • Robert Barro (2006) argues a correct probability of a significant catastrophe explains much of the equity premium, about 300 basis points • 2% change of a 15% to 45% GDP decline

  19. Taxes • 10% stock return: 6% post tax with a 40% tax rate • Gannon and Blum (2006) apply this to S&P500 assuming 20% turnover from 1961-2005, using actual capital gains, dividend top-tier tax rates • Cap gain avg: 26% • Top tax rate avg; 49% (includes 6% state tax) • Total after tax equity return 6.72%, vs. 10.62% pre tax • Long Term Municipal Bond Buyer Index return: 6.14%

  20. Equity Premium Subtractions • Geometric vs. Arithmetic Averaging 2.0% • Survivorship Bias 3.0% • Peso Problems 3.0% • Post WW2 Reduct. in Eq. Premium 3.0% • Taxes 2.0% • Adverse Market Timing 2.0% • Transaction Costs 2.0% • Sum 17.0% • Most estimates around 3.5% for equity premium. With these additions, the Marginal Investor clearly could be seeing a 0% equity premium.

  21. Bottom Line • Risk premium exists in really low risk areas like • AAA-BBB spread • Short end of yield curve • Equity Risk Premium a mirage • Reasonable costs take it to zero for your average investor • Why is finance so remunerative? Selling dreams about getting rich, misdirection. • When alpha is possible, people are benchmarking, and selling hope

More Related