Damodaran on the Equity Risk Premium

The Equity Risk Premium is one of the central concepts of finance theory and practice. However, when we teach it in class (usually as part of the CAPM), we tend to do a lot of hand-waving and tell students to use historical ERPs. Aswath Damodaran of New York University has an excellent piece on SSRN titled "Equity Risk Premiums: Determinants, Estimation, and Implications" that's a must-read whether you're a professor, student, or practitioner. Here's the abstract:

Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and volatile. We look at two other approaches to estimating equity risk premiums - the survey approach, where investors and managers are asked to assess the risk premium and the implied approach, where a forward-looking estimate of the premium is estimated using either current equity prices or risk premiums in non-equity markets. We close the paper by examining why different approaches yield different values for the equity risk premium, and how to choose the "right" number to use in analysis. (In an addendum, we also look at equity risk premiums during the market crisis, starting on September 12, 2008 through October 16, 2008.)

Read the whole thing here.

I'd Eat That

I just stopped by my favorite (on campus) coffee, bagel, and sandwich shoppe - I'm spending the afternoon grading exams that are due back tomorrow (groan).

Their latest sandwich offering is a Veggie Burger with Tomato, Onion, Provolone cheese, and Bacon. That's right - a veggie burger with bacon - probably the only way I'd eat one of those. Actually, it sounds pretty good. Bacon improves just about everything.

Talking With Practitioners

Unknown University recently had a function where they brought back a number of prominent alumni to talk about various topics. At dinner after the function, I ended up at a table with an MD from a major investment bank who manages about 10Billion overall in both traditional funds and alternative investments in the market where I'm currently doing some research. It was not by chance - I offered to lead a session that he was the main speacker for, and asked to be put at his table afterward.

So, at dinner (in between him checking his Blackberry every few minutes (dan - that is distracting), I got a chance to see whether my story about what I saw in my data passed the "sniff test" from someone who works in that market on a daily basis. Luckily, it did. Having topped that bar, we started talking about what sorts of things his firm has done in terms of research on the particular topic. So, it looks like I made a connection that could result in my getting some pretty scarce data in exchange for doing some research for the guy. It's a win-win - he gets some relatively low-cost access to eggheads, and I and my coauthor get some scarce data and access to people who can tell us far more about the markets involved than we could learn from academic articles and textbooks.

So, the bottom line is - If you're an academic who works on related topics, talk to practitioners. It's good for you.