The Phenomena Behind Equity Risk Premium Discussion For 35 Years

Investment analysis is said to be psychological in various aspects. The irregularity observed in financial markets in recent times has yet again brought to question the practical application of traditional financial theory and the Efficient Market Hypothesis. There is therefore the need to put this base of accepted finance theory under scrutiny. The foundation of one of the broadly examined problems with traditional financial theory is the effect of psychological influences on individuals’ behavior towards investment. According to Slovic (1972), Daniel, Hirshleifer ,Subrahmanyam (1998) and Hilton (2001), they believe that financial markets are functioning at a rapid and increasingly cut throat environment and have been transformed in several ways, one of which is technological. The growing rate of technology has had an immense effect on trading and investment. Technology has aided in allowing information to be easily accessible to investors, but there has been little focus on the issue of interpreting the information skillfully. It is important to note that the appropriate use of information is a crucial part in making investment decisions.

The risk premium is equal to the difference between the risk-free rate and the expected market return. The case study provides two historical equity risk premiums; the geometric and arithmetic mean. The conventional wisdom is that the geometric mean is considered a better estimate for valuation over long periods, while the arithmetic mean a better estimate for valuation over shorter periods. To coincide with the choice of the 20yr yield on U.S. Treasuries, the geometric mean was therefore chosen for this analysis i.e. (Rm-Rf) = 5.9%

Bodie Z., Zane A. and Marcus AJ. 1996. Investments. Third Edition. Irwin/McGraw-Hill. Jones CP. 1998. Investments. Sixth Edition. John Wiley & Sons. Sharpe WF, Alexander G. and Bailey JV. 1999. Investments. Sixth Edition. Prentice- Hall. Macaulay F. 1938. Some theoretical problems suggested by the movements of interest rates, bond yield, and stock prices in the United States since 1856. New York: National

Efficient Market Hypothesis has been controversial issues among researcher for decades. Until now, there is no united conclusion whether capital markets are efficiency or not. In 1960s, Fama (1970) believed that market is very efficient despite there are some trivial contradicted tests. Until recently, both empirical and theatrical efficient market hypothesis was being disputed by behavior finance economist. They have found that investor have psychological biases and found evidences that some stocks outperform other stocks. Moreover, there are evidences prove that market are not efficient for instance financial crisis, stock market bubble, and some investor can earn abnormal return which happening regularly in stock markets all over the world. Therefore, the purpose of this essay is to demonstrate that Efficient Market Hypothesis in stock (capital) markets does not exist in the real world by proofing four outstanding unrealistic conditions that make market efficient: information is widely available and cost-free, investor are rational, independent and unbiased, There is no liquidity problem in stock market, and finally stock prices has no pattern.

So instead, we will look at comparable firms. Firms in the same industry pursuing the same types of projects will have the same sorts of risks, thus their asset betas will be approximately the same. The returns we calculate for these firms, based on stock price movement, dividends, and stock splits, are their equity betas.

The role of risk-free rate in the financial analysis is of vital importance because it allows the cost of both equity and total capital to be assessed. For a particular security to be characterized as risk-free, the actual returns should always be equal to the expected one. The aforementioned fact presupposes the satisfaction of two criteria: The first indicates that the stock is free of default risk and the second declares that there can be no reinvestment risk (Damodaran 1998). However, no security is truly risk-free due to the exposure of its returns to inflation risk. Even, Treasury inflation-protected securities (TIPS) , which are indexed to inflation, are not risk-free (Shen1995).

As indicated by the case study S&P 500 index was use as a measure of the total return for the stock market. Our standard deviation of the total return was used as a one measure of the risk of an individual stock. Also betas for individual stocks are determined by simple linear regression. The variables were: total return for the stock as the dependent variable and independent variable is the total return for the stock. Since the descriptive statistics were a lot, only the necessary data was selected (below table.)

Despite numerous periods of global financial excesses, and subsequent corrections, over the past 30 years, the returns on equities and bonds in the US and Europe have been considerably above their long-term averages. The outperformance has been most pronounced in long-dated government bonds. The average annual real return on these instruments between 1985 and 2014 was +5.0% in the US and +5.9% in Europe, compared to long-run returns of +1.7% and +1.6%, respectively. Meanwhile, the outperformance of equities between 1985 and 2014 was more modest. The average annual real return on US equities was +7.9%, compared to a long-run average of +6.5%, while these respective measures in Europe were +7.9% and +4.9%. Two major related factors can predominantly explain this golden period for both bonds and equities, namely the taming of inflation and the subsequent decline in interest rates to historic lows. Both inflation and interest rates are important inputs into valuation models for long duration assets, thereby implying that their respective influences on returns over the past 30 years have, therefore, been largely felt through changing valuations. Equity returns are, however, explained by other factors, including economic and corporate fundamentals, of varying complexity. Positive demographics, technological innovation, and global supply chains have also helped to contain costs, while the emergence of new markets, notably China,

Some financial experts argue that certain macroeconomic variables can be used for predicting stock returns. One such macroeconomic variable is the Consumption to Wealth ratio. I will now examine how effective this variable is in predicting future stock market returns. The expected excess returns vary with the growths and dips in the business cycle, therefore, they should be predictable at different stages of the cycle. To examine the relationship, we note that aggregate consumption, asset holdings and labour income all share the same long term trend, but in the short term they may deviate substantially from one another. According to Lettau Ludvigson 2001, “we study the role of these transitory deviations from the common trend in

Despite numerous periods of global financial excesses, and subsequent corrections, over the past 30 years, the returns on equities and bonds in the US and Europe have been considerably above their long-term (100 year) averages. The outperformance has been most pronounced in long-dated government bonds. The average annual real return on these instruments between 1985 and 2014 was +5.0% in the US and +5.9% in Europe, compared to long-run returns of +1.7% and +1.6%, respectively. Meanwhile, the outperformance of equities between 1985 and 2014 was more modest. The average annual real return on US equities was +7.9%, compared to a long-run average of +6.5%, while these respective measures in Europe were +7.9% and +4.9%. Two major related factors can predominantly explain this golden period for both bonds and equities, namely the taming of inflation and the subsequent decline in interest rates to historic lows. Both inflation and interest rates are important inputs into valuation models for long duration assets, thereby implying that their respective influences on returns over the past 30 years have, therefore, been largely felt through changing valuations. Other factors, of varying complexity, can help to explain impressive equity returns, including economic and corporate fundamentals. Positive demographics, technological innovation, and global supply chains have also helped to contain costs, while the emergence of new markets,

The analysis of this paper will derive the validity of the Fama and French (FF) model and the efficiency of the Capital Asset Pricing Model (CAPM). The comparison of the Fama and French Model and CAPM (Sharpe, 1964 & Lintner, 1965) uses real time data of stock market to practise its efficacy. The implication of the function in realistic conditions would justify the utility of the CAPM theory. The theory suggests that the expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the expected return on the market portfolio, the variance of the return on the market portfolio, and

The third quarter of 2015 was no fun. Having been spoiled by six years of steady gains across all kinds of financial assets, we might regard the recent episode of market volatility as a rude intrusion upon our ongoing right to steadily increasing account values. Of course, it doesn’t work that way. Volatility in both directions comes with the territory for long-term investors. Indeed, in some academic circles the belief is held tightly that it is volatility, and only volatility, that entitles us to earn any return at all on our investments. Our willingness to endure the ebbs and flows of wealth over time, to put our capital at real risk, earns our ultimate compensation.

Since 1999, the economy has been in a downward trend. The majority of people who had invested in the stock market now known as the great stock bubble or fraud bubble were given a false sense of security and they felt the market would just keep climbing. Were there signs that investors could have looked for to predict the economic downturn? If investors had looked for the signs, maybe they could have changed their direction of investment. This paper will investigate the characteristics of bonds and see if the bond market has proven to be a safe haven for those who were wise enough to invest in it. When the economy is in a downward trend why should more people invest in bonds?

However, these theories only apply to assets with infinite lives (land and shares), as investors know that assets with finite terms will be redeemed for a specified value at maturity and this limits their secondary market price. According to Froot and Obstfeld, bubbles result from investors incorrectly estimating fundamentals. For example, shareholders may be unable to forecast industry changes that affect future profitability and are forced to condition expectations of future cash-flows on current payments. This ‘intrinsic rational bubble’ theory explains several empirical observations, including why share prices over-react to dividend changes.

Also, significant research on equity premium puzzle was made by the Siegel. Siegel examined returns on US stocks and fixed income securities starting from year 1802 till 1990. By dividing entire period into three phases 1802 - 1870, 1871 – 1925, 1925 – 1990, he discovered that income from investing in