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In the last chapter, we presented the argument that the expected return on an
equity investment should be a function of the market or non-diversifiable embedded in
that investment. In this chapter, we turn our attention to how best to estimate the
parameters of market risk in each of the models described in the previous chapter - the
capital asset pricing model, the arbitrage pricing model and the mutli-factor model. We
will present three alternative approaches for measuring the market risk in an investment;
the first is to use historical data on market prices for the firm considering the project, the
second is to use the market risk parameters estimated for other firms that are in the same
business as the project being analyzed and the third is to use accounting earnings or
revenues to estimate the parameters.
In addition to estimating market risk, we will also discuss how best to estimate a
riskless rate and a risk premium (in the CAPM) or risk premiums (in the APM and multi-
factor models) to convert the risk measures into expected returns. We will present a
similar argument for converting default risk into a cost of debt, and then bring the
discussion to fruition by combining both the cost of equity and debt to estimate a cost of
capital, which will become the minimum acceptable hurdle rate for an investment.

Cost of Equity
The cost of equity is the rate of return that investors require to make an equity
investment in a firm. All of the risk and return models described in the previous chapter
need a riskfree rate and a risk premium (in the CAPM) or premiums (in the APM and
multi-factor models). We will begin by discussing those common inputs before we turn
our attention to the estimation of risk parameters.

I. Riskfree Rate
Most risk and return models in finance start off with an asset that is defined as risk
free and use the expected return on that asset as the risk free rate. The expected returns on

risky investments are then measured relative to the risk free rate, with the risk creating an
expected risk premium that is added on to the risk free rate.

Requirements for an asset to be riskfree
We defined a riskfree asset as one where the investor knows the expected returns
with certainty. Consequently, for an investment to be riskfree, i.e., to have an actual
return be equal to the expected return, two conditions have to be met “
There has to be no default risk, which generally implies that the security has to be

issued by a government. Note, though, that not all governments are default free and
the presence of government or sovereign default risk can make it very difficult to
estimate riskfree rates in some currencies.
There can be no uncertainty about reinvestment rates, which implies that there are no

intermediate cash flows. To illustrate this point, assume that you are trying to
estimate the expected return over a five-year period and that you want a risk free rate.
A six-month treasury bill rate, while default free, will not be risk free, because there
is the reinvestment risk of not knowing what the treasury bill rate will be in six
months. Even a 5-year treasury bond is not risk free, since the coupons on the bond
will be reinvested at rates that cannot be predicted today. The risk free rate for a five-
year time horizon has to be the expected return on a default-free (government) five-
year zero coupon bond.
This clearly has painful implications for anyone doing corporate financial analysis, where
expected returns often have to be estimated for periods ranging from multiple years. A
purist's view of risk free rates would then require different risk free rates for each period
and different expected returns. As a practical compromise, however, it is worth noting
that the present value effect of using risk free rates that vary from year to year tends to be
small for most well behaved1 term structures. In these cases, we could use a duration
matching strategy, where the duration of the default-free security used as the risk free
asset is matched up to the duration2 of the cash flows in the analysis. If, however, there

1 By well behaved term structures, I would include a normal upwardly sloping yield curve, where long term
rates are at most 2-3% higher than short term rates.
2 In investment analysis, where we look at projects, these durations are usually between 3 and 10 years. In
valuation, the durations tend to be much longer, since firms are assumed to have infinite lives. The duration

are very large differences, in either direction, between short term and long term rates, it
does pay to stick with year-specific risk free rates in computing expected returns.

Cash Flows and Risk free Rates: The Consistency Principle
The risk free rate used to come up with expected returns should be measured
consistently with how the cash flows are measured. If the cashflows are nominal, the
riskfree rate should be in the same currency in which the cashflows are estimated. This
also implies that it is not where a project or firm is domiciled that determines the choice
of a risk free rate, but the currency in which the cash flows on the project or firm are
estimated. Thus, Disney can analyze a proposed project in Mexico in dollars, using a
dollar discount rate, or in pesos, using a peso discount rate. For the former, it would use
the US treasury bond rate as the riskfree rate but for the latter, it would need a peso
riskfree rate.
Under conditions of high and unstable inflation, valuation is often done in real
terms. Effectively, this means that cash flows are estimated using real growth rates and
without allowing for the growth that comes from price inflation. To be consistent, the
discount rates used in these cases have to be real discount rates. To get a real expected
rate of return, we need to start with a real risk free rate. While government bills and
bonds offer returns that are risk free in nominal terms, they are not risk free in real terms,
since expected inflation can be volatile. The standard approach of subtracting an
expected inflation rate from the nominal interest rate to arrive at a real risk free rate
provides at best an estimate of the real risk free rate. Until recently, there were few
traded default-free securities that could be used to estimate real risk free rates; but the
introduction of inflation-indexed treasuries has filled this void. An inflation-indexed
treasury security does not offer a guaranteed nominal return to buyers, but instead
provides a guaranteed real return. In early 2004, for example, the inflation indexed US
10-year treasury bond rate was only 1.6%, much lower than the nominal 10-year bond
rate of 4%.

in these cases is often well in excess of ten years and increases with the expected growth potential of the

4.1. ˜: What is the right riskfree rate?
The correct risk free rate to use in the capital asset pricing model
a. is the short term government security rate
b. is the long term government security rate
c. can be either, depending upon whether the prediction is short term or long term.

In Practice: What if there is no default-free rate?
Our discussion, hitherto, has been predicated on the assumption that governments do not
default, at least on local borrowing. There are many emerging market economies where
this assumption might not be viewed as reasonable. Governments in these markets are
perceived as capable of defaulting even on local borrowing. When this is coupled with
the fact that many governments do not borrow long term locally, there are scenarios
where obtaining a l risk free rate in the local currency, especially for the long term,
becomes difficult. In these cases, there are compromises that give us reasonable estimates
of the risk free rate.
Look at the largest and safest firms in that market and use the rate that they pay on

their long-term borrowings in the local currency as a base. Given that these firms, in
spite of their size and stability, still have default risk, you would use a rate that is
marginally lower3 than the corporate borrowing rate.
If there are long term dollar-denominated forward contracts on the currency, you can

use interest rate parity and the treasury bond rate (or riskless rate in any other base
currency) to arrive at an estimate of the local borrowing rate.4
You could adjust the local currency government borrowing rate by the estimated

default spread on the bond to arrive at a riskless local currency rate. The default

3 Reducing the corporate borrowing rate by 1% (which is the typical default spread on highly rated
corporate bonds in the U.S) to get a riskless rate yields reasonable estimates.
4 For instance, if the current spot rate is 38.10 Thai Baht per US dollar, the ten-year forward rate is 61.36
Baht per dollar and the current ten-year US treasury bond rate is 5%, the ten-year Thai risk free rate (in
nominal Baht) can be estimated as follows.
" 1 + Interest RateThai Baht %10
61.36 = (38.1)$ '
1 + 0.05
# &
Solving for the Thai interest rate yields a ten-year risk free rate of 10.12%.


spread on the government bond can be estimated using the local currency ratings5 that
are available for many countries. For instance, assume that the Brazilian government
bond rate (in nominal Brazilian Reals (BR)) is 14% and that the local currency rating
assigned to the Brazilian government is BB+. If the default spread for BB+ rated
bonds is 5%, the riskless Brazilian real rate would be 9%.
Riskless BR rate = Brazil Government Bond rate “ Default Spread = 14% -5% = 9%

II. Risk premium
The risk premium(s) is clearly a significant input in all of the asset pricing
models. In the following section, we will begin by examining the fundamental
determinants of risk premiums and then look at practical approaches to estimating these

What is the risk premium supposed to measure?
The risk premium in the capital asset pricing model measures the extra return that
would be demanded by investors for shifting their money from a riskless investment to an
average risk investment. It should be a function of two variables:
1. Risk Aversion of Investors: As investors become more risk averse, they should
demand a larger premium for shifting from the riskless asset. While of some of this
risk aversion may be inborn, some of it is also a function of economic prosperity
(when the economy is doing well, investors tend to be much more willing to take risk)
and recent experiences in the market (risk premiums tend to surge after large market
2. Riskiness of the Average Risk Investment: As the riskiness of the average risk
investment increases, so should the premium. This will depend upon what firms are
actually traded in the market, their economic fundamentals and how good they are at
managing risk. For instance, the premium should be lower in markets where only the
largest and most stable firms trade in the market.

5Ratings agencies generally assign different ratings for local currency borrowings and dollar borrowing,
with higher ratings for the former and lower ratings for the latter.

Since each investor in a market is likely to have a different assessment of an acceptable
premium, the premium will be a weighted average of these individual premiums, where
the weights will be based upon the wealth the investor brings to the market. Put more
directly, what Warren Buffett, with his substantial wealth, thinks is an acceptable
premium will be weighted in far more into market prices than what you or I might think
about the same measure.
In the arbitrage pricing model and the multi-factor models, the risk premiums
used for individual factors are similar wealth-weighted averages of the premiums that
individual investors would demand for each factor separately.

˜ 4.2: What is your risk premium?
Assume that stocks are the only risky assets and that you are offered two investment
A riskless investment (say a Government Security), on which you can make 4%

A mutual fund of all stocks, on which the returns are uncertain

How much of an expected return would you demand to shift your money from the
riskless asset to the mutual fund?
a. Less than 4%
b. Between 4-6%
c. Between 6-8%
d. Between 8-10%
e. Between 10-12%
f. More than 12%
Your answer to this question should provide you with a measure of your risk premium.
(For instance, if your answer is 6%, your premium is 2%.)

Estimating Risk Premiums
There are three ways of estimating the risk premium in the capital asset pricing
model - large investors can be surveyed about their expectations for the future, the actual
premiums earned over a past period can be obtained from historical data and the implied
premium can be extracted from current market data. The premium can be estimated only
from historical data in the arbitrage pricing model and the multi-factor models.

1. Survey Premiums
Since the premium is a weighted average of the premiums demanded by
individual investors, one approach to estimating this premium is to survey investors about
their expectations for the future. It is clearly impractical to survey all investors; therefore,
most surveys focus on portfolio managers who carry the most weight in the process.
Morningstar regularly survey individual investors about the return they expect to earn,
investing in stocks. Merrill Lynch does the same with equity portfolio managers and
reports the results on its web site. While numbers do emerge from these surveys, very
few practitioners actually use these survey premiums. There are three reasons for this
“ There are no constraints on reasonability; individual money managers could provide
expected returns that are lower than the riskfree rate, for instance.
“ Survey premiums are extremely volatile; the survey premiums can change
dramatically, largely as a function of recent market movements.
“ Survey premiums tend to be short term; even the longest surveys do not go beyond
one year.

˜ 4.3: Do risk premiums change?
In the previous question, you were asked how much of a premium you would demand for
investing in a portfolio of stocks as opposed to a riskless asset. Assume that the
market dropped by 20% last week, and you were asked the same question today.
Would your premium
a. be higher?
b. be lower?
c. be unchanged?

2. Historical Premiums
The most common approach to estimating the risk premium(s) used in financial
asset pricing models is to base it on historical data. In the arbitrage pricing model and
multi- factor models, the raw data on which the premiums are based is historical data on

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