Chapter 11 - Cost of Equity: Beta and Risk Premium

Abstract

Market-risk premium is the expected rate of return on the aggregate stock market in excess of the risk-free interest rate. This chapter explains the fact that the betas and volatilities are very unstable parameters over time that measure the risk. A share's volatility measures the share's total risk—that is, both the market risk and the diversifiable risk. A share's beta measures the incremental risk added by a share to a given portfolio. The market risk is the risk that cannot be eliminated by creating a diversified portfolio. The beta's instability is particularly important while determining a share's expected return because this may vary depending on the data that are used to calculate the beta. Given the beta's instability and the low significance of the historical betas, there are increasingly more companies that calculate the qualitative beta of companies or investment projects. The market-risk premium is the incremental return demanded by the investors from the equity above the risk-free rate. The most direct way to calculate the market-risk premium is to carry out a survey of analysts or investors.