Discussion Of The Risk Premium
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WHAT IS THE RISK PREMIUM?
In the CAPM model, the risk premium is calculated as the difference between the expected market return (Rm) and the risk-free rate of return (Rf). The time periods used for Rm and Rf should be consistent. For example, the expected market return (Rm) of 12.33% I used in the CAPM calculation is based on historical return data covering the period December 31, 1991 through March 31, 2005. Therefore, in order to determine the risk premium, I have used the average risk-free rate over that same time period. The average risk-free rate for this period was 3.73%, as shown on Schedule TMR-4.
Therefore, the market risk premium in my CAPM calculation is 8.60%.
As shown on page 2 of Schedule TMR-2, Mr. Merediths proposed market equity
risk premium is 15.87%.
ABOVE YOU INDICATED THAT THE MARKET AVERAGE RISK PREMIUM IN YOUR CAPM CALCULATION IS 8.6%. HOW DOES YOUR ESTIMATE OF RISK PREMIUM COMPARE TO OTHER ESTIMATES OF THE RISK PREMIUM?
As already discussed, the market equity risk premium in my CAPM calculation is 8.60%.
This is a relatively high market equity risk premium compared to other estimates I am aware of. The estimates of the equity risk premium among the prominent studies I am aware of, range from a low of 5.5% to a high of 8.63%. Therefore, the estimate of the market equity risk premium in my CAPM calculation is on the high side of that range.
For example, a 2000 study conducted by Ivo Welch involved a survey of 226 academic financial economists to arrive at a “consensus” estimate of the equity risk premium. That study concluded that the consensus estimate among those 226 economists for the equity risk premium is 7% per year over 10 and 30-year time horizons, and 6% to 7% over 1 and 5-year time horizons.