Forward-Looking Market Risk Premium

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Risk premium is the most important concept in finance, and its modeling has been a core of the modern finance theory. Risk premium is often used in financial research and applications, such as determining market efficiency, setting asset allocation (the decision to allocate assets between stocks and bonds), applying the Capital Asset Pricing Model (CAPM) to determine cost of capital, and forecasting growth of investment portfolios, among others.

Risk premium is obviously a forward-looking concept. In essence, it is compensationfor holding an asset that will yield an uncertain return. In practice, however, the mostcommonly used method for estimating risk premium is average historical realized excessreturns (Welch, 2000; Damodaran, 2008). The literature indicates that realized excess returnand expected risk premium are fundamentally different (Elton, 1999; Arnott and Bernstein,2002). Conceptually, using historical realized excess return relies on the belief that noiseswill cancel out in the long run. Thus, using historical risk premium is subject to tradeoffbetween reflecting recent market condition and estimation accuracy. Basically, the longerthe estimation time period, the more statistically accurate the result becomes. But a longertime period also results in a higher likelihood of a regime shift in the estimation period sothat the risk premium estimate becomes distorted by earlier regime(s). Download free Forward-Looking Market Risk Premium.pdf here

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