Risk Premium Model Research Articles

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The Assessment Of Market Risk Premium In South Africa

<p class="MsoNormal" style="text-indent: 0in; margin: 0in 0.5in 0pt; mso-pagination: none;"><span style="font-family: "Times New Roman","serif"; font-size: 10pt;" lang="EN-GB">This paper makes use of time-varying parameter GARCH-M model to estimate the risk aversion parameter for the South African stock market. The paper further compares the forecasts performance of a time-varying risk premium model with that of a constant risk premium model in predicting stock market returns on the South African stock exchange. The findings of the paper show that risk premium is time varying and indicate that stock market in South Africa is vulnerable to external shocks. Moreover, the paper finds that the time-varying GARCH-M model outperforms the fixed parameter GARCH-M model in predicting stock returns when short-term forecast horizons are used. </span></p>

The Conditional CAPM and Time Varying Risk Premium for Equity REITs

Executive Summary.Given the recent interest in Real Estate Investment Trusts (REITs), this study investigates whether REITs provide investors with a superior risk-return trade off. Utilizing a conditional CAPM, the findings reveal that equity REITs have outperformed the stock market with an average abnormal annual return of 2.25% with a low time-varying beta of around .24 during the June 1995 to December 2003 period. Utilizing time-varying risk premium models for equity REITs with GARCH specifications, the findings reveal that both the ARCH and GARCH effects are significant in the estimated models. In addition, the volatility shocks are quite persistent. The results show that the market returns and the first-order autocorrelation help explain the excess returns of equity REITs. However, the movement of interest rates contributes to equity REIT returns only when the market return is not present in the models.

An empirical study of the value-relevance of using proportionate consolidation accounting for investments in joint ventures

This research examines bond risk premiums to determine whether creditors of companies with investments in joint ventures reflect legal or implicit measures of the debts of joint ventures. The legal view suggests that the amount of potential loss from an investment in a joint venture is limited to the investment. The implicit view suggests that the operations of the joint venture and the venturer are interdependent. Equity method accounting reflects the legal view and proportionate consolidation reflects the implicit view. The study examines whether bond risk premiums are more highly associated with accounting numbers from proportionate consolidation than equity method accounting. The study uses data from 10Ks, the Wall Street Journal, and Moody's Bond Record from May 1, 1995 through April 30, 1998. These 4 years are used because US interest rates were fairly stable during this period, which is an important factor when examining bond risk premiums. Additionally, the companies in the study needed to remain stable across the window of study – no mergers, acquisitions, buy-outs, or liquidations – in order to maintain a comparative sample over the entire time period. The risk premium model uses measures of default that change between equity method accounting and proportionate consolidation. Differences in the explanatory power of the model determine how creditors view the joint venture debts. The study shows that approximately half of equity investments represent investments in joint ventures. Furthermore, the average joint venture uses debt to finance about two-thirds of the assets. The results show that proportionate consolidation fails to improve the explanatory power of the model when examining the entire set of companies that invest in joint ventures. However, the data reject the null hypothesis of no improvement with proportionate consolidation when examining companies who guarantee the debt of their joint venture. The policy implication of this study indicates that a change to proportionate consolidation would provide more value-relevant information to creditors when companies guarantee the debt of the joint venture.

Capital investment appraisal: a new risk premium model

Net Present Value (NPV) is the principal valuation model of the financial literature. Firms are accordingly directed, as a matter of good practice, to adopt the model for selecting investment projects, yet questionnaire surveys show that the adoption rate has been very slow and the quality of usage questionable. In particular, alternative risk measures are popular amongst practitioners. In this paper we remodel the treatment of risk in the NPV model based on assumptions that seem realistic in an organizational or operational, as opposed to a personal, investment context. We derive formulas for calculating: the appropriate discount rate, a ‘risk horizon’ (where the risk premium exceeds the expected value), and a maximum default hazard point for projects. These measures provide a rationale for non‐NPV approaches to risk measurement in questionnaire responses and offer a practical benefit to investors.

Real exchange rate determination: Empirical observations from East-Asian countries

In this paper the models for the real exchange rate determination are re-examined between Japan and five East-Asian countries. Two important findings are reported. First, the real interest rate-bias model is valid for Korea-, Malaysia-, Indonesia-, and Philippines-Japan, and the productivity-bias model is valid for Indonesia-, and Philippines-Japan: that is, the coefficients of relative variables are stable and statistically significant. Second, there is no evidence that the political risk premium model is valid.

World Income Components: Measuring and Exploiting Risk-Sharing Opportunities

A method is constructed for decomposing the variance of changes in incomes in the world into components, to indicate the most important risk-sharing opportunities among people of the world. A constant absolute risk premium (CARP) model, an intertemporal general-equilibrium model of the world, is presented to permit optimal contract design. For a contract designer maximizing a social welfare function, the optimal contracts maximize the equilibrium world real interest rate. Securities are defined in terms of eigenvectors of a transformed variance matrix. The method is applied using Penn World Table data on the G-7 countries, 1950–1992. (JEL F00, G00, G10)

Exchange risk premia in the European monetary system

In this article, a survey database of exchange rate expectations is employed to examine EMS exchange risk premia. We are able to test a risk premium model directly, i.e. without having to rely on the rational expectations assumption. The results indicate that time-varying risk premia are almost always present and that a (G)ARCH-in-mean specification is often quite succesful in capturing the essential features of the premia.

Testing the risk premium and cost-of-carry hypotheses for currency futures contracts

The Risk Premium and Cost-of-Carry hypotheses regarding the pricing of futures contracts are tested using nested and non-nested procedures. Cointegrating relationships among the Australian dollar spot and futures prices, and US and Australian risk-free rates of interest, suggest an error-correction representation for the Risk Premium model, and two alternative error-correction formulations for the Cost of-Carry hypothesis. Two significant structural breaks in the futures price series permit a testing of appropriate models for the full sample in the presence of these breaks, for the full sample without explicitly modelling the breaks, and for various subsamples created by these structural breaks. Unit root and cointegration tests yield alternative non-nested formulations of the Cost-of-Carry model for three different subsamples, thereby leading to the use of nested and non-nested tests. The outcomes of these tests provide substantial support for the Cost-of-Carry hypothesis in the pricing of Australian dol...

Do bubbles and time-varying risk premiums affect stock prices? a Kalman filter approach

This paper separates the validity of the specification of the fundamental stock price model from the implications of bubbles. The time–varying risk premium model (Poterba and Summers, 1986) is used to explicitly derive the misspecification component. We construct a state–space model and use Kalman filter to estimate the relationships between the observable price/dividend and the unobservable bubbles/misspecification. The model is applied to CRSP and S&P 500 data. The results show that the fundamental price model does not describe the market prices well. The time–varying risk premium is important in explaining stock price movements. No significant evidence of bubbles is found.

Estimation of alternative pricing models for currency futures contracts

The Risk Premium and Cost-of-Carry models regarding the pricing of Australian dollar futures contracts traded on the International Monetary Market of the Chicago Mercantile Exchange are estimated and compared. Cointegrating relationships among the Australian dollar spot and futures prices, and US and Australian risk-free rates of interest, suggest an error-correction representation for the Risk Premium model, and two alternative error-correction formulations for the Cost-of-Carry model. Two significant structural breaks in the futures price series permit estimation of appropriate models for the full sample in the presence of these breaks, for the full sample without explicitly modelling the breaks, and for various sub-samples created by these structural breaks. The Risk Premium and Cost-of-Carry formulations are estimated for all sample sets, the models obtained are found to be statistically adequate, and the qualitative results are reasonably robust across different sample sets for both models.

ESTIMATING THE EQUITY RISK PREMIUM AND EQUITY COSTS: NEW WAYS OF LOOKING AT OLD DATA

This article examines three alternative ways of estimating the expected return on the equity market in using the CAPM or some other risk premium model. The three techniques are (1) direct estimation of the average nominal equity return for use as a forecast nominal equity return; (2) estimation of the average real equity return, which can then be added to a forecast inflation rate; and (3) estimation of an average equity risk premium, which is then added to a current risk‐free rate. Ibbotson and Sinquefeld's data on annual holding period returns are used to test the validity of their assumption that the equity risk premium follows a random walk and that the third of these approaches is thus the best method.The paper reaches three major conclusions. First, each of these three techniques involves a “bias” of some kind. The use of average equity returns as a forecast is subject to “risk‐free rate” and “inflation rate” biases, while the use of an average equity risk premium is subject to a “term premium” bias. As a result, only the data can tell us which approach is best. Second, from analyzing equity and bond return data and the trend in interest rates, the author concludes that the term premium bias when using average historic equity risk premium is by far the largest of the three sources of bias. Indeed, the popular practice of adding an historic average equity risk premium to the 30‐year Treasury bond rate significantly overstates equity costs. Third, after examining equity rates of return back to 1871, the author concludes that the real equity return seems to follow a process that is close to a random walk and is thus the “best” of the three techniques to use as a “naive” forecast.

EMS exchange rate expectations and time-varying risk premia

In this paper we examine exchange risk premia employing a survey dataset of EMS exchange rates. We are able to test a risk premium model directly, i.e. without having to rely on the rational expectations assumption. Our results indicate that time-varying risk premia are present in almost all cases and that a GARCH-in-mean specification for the premium is often appropriate.

Some Evidence on the Efficiency of the Forward Market for Foreign Exchange from Monte-Carlo Experiments

A Monte-Carlo approach is used to provide new insights into tests of the forward foreign exchange market efficiency hypothesis (FMEH). A whole range of alternative hypotheses regarding price determination in the forward market is examined for the /DM case, including different expectations schemes, a risk premium model derived from international asset pricing theory and the novel idea that the empirical evidence on the FMEH is the result of intervention by monetary authorities. The latter hypothesis as well as the hypothesis that expectations are formed in a static manner rather than rational appear to work the best.

Modelling risk premia in international asset markets

The intertemporal capital asset pricing model (ICAPM) has been widely used as a vehicle to explain the predictability of excess returns in forward foreign exchange markets. This approach ignores the heterogeneity in the assets actually traded in international asset markets. In this paper it is shown that the latent variable risk premium model is not rejected by the data when tested on a portfolio including equity and bonds in four currencies. However, application of a more general test rejects parameter stability, suggesting that the latent variable model is not as successful as the previous tests would imply.

Modelling the Yield Curve

expectations model, a risk premium model and a market segmentation model. Among the innovations in the present study, we develop the vector autoregressive methodology introduced by Campbell and Shiller (I987) for testing present value models to the case where the frequency of data observation is finer than the maturity of the short-term instrument. In addition, this study is the first to use the interest rate data generated by the ' new' Bank of England method of measuring the yield curve, which is thought to be superior to data on Treasury Bond yields previously published by the Bank (Bank of England I99o).2

A comparison of risk-premium forecasts implied by parametric versus nonparametric conditional mean estimators

This paper computes parametric estimates of a time-varying risk premium model and compares the one-step-ahead forecasts implied by that model with those given by a nonparametric kernel estimator of the conditional mean function. The conditioning information used for the nonparametric analysis is that implied by the theoretical model of time-varying risk. Thus, the kernel estimator is used, in conjunction with a nonparametric diagnostic test for in-sample residual nonlinear structure, to assess the adequacy of the parametric model in capturing any structure in the excess returns. Our results support the parametric specification of an asset pricing model in which the conditional beta is the ratio of the relevant components of the conditional covariance matrix of returns modelled as a bivariate generalized ARCH process. Although the predictable component of the conditional moments is relatively small, the parametric estimator of the risk premia has somewhat more out-of-sample forecasting ability than does the kernel estimator. Hence, the superior in-sample performance of the latter may be attributed to overfitting.

Evidence of Risk Premiums in Foreign Currency Futures Markets

benchmark portfolios for con-sumption and wealth. When the parameters rep-resenting the prices of the covariance risks areheld constant, no risk premiums are detected.However, when these prices are allowed to varywith the conditional expected returns and vari-ances of the benchmark portfolios, possibly reflect-ing changing investment opportunities, strong evi-dence of risk premiums is obtained.Recent examinations of foreign currency futures datahave tested the hypothesis that today’s futures priceis an unbiased predictor of tomorrow’s price againstan unspecified alternative hypothesis. The accumu-lated evidence against the unbiasedness hypothesishas not been accompanied by evidence consistentwith a particular equilibrium risk premium model.

A risk premium model for market timing

A risk premium model for market timing