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Equity Premium

Governments are largely insulated from market forces. Companies are not. Investments in stocks therefore carry substantial risk in comparison with holdings of government bonds, notes or bills. The marketplace presumably rewards risk with extra return. How much of a return premium should investors in equities expect? These blog entries examine the equity risk premium as a return benchmark for equity investors.

Persistent Usefulness of Emerging Markets in Equity Diversification

How does consideration of return distribution tails (not just linear correlations) affect assessment of global equity diversification benefits? In their May 2012 paper entitled “Is the Potential for International Diversification Disappearing? A Dynamic Copula Approach”, Peter Christoffersen, Vihang Errunza, Kris Jacobs and Hugues Langlois examine the evolution of equity market diversification benefits based on a methodology that accommodates non-linearity in the relationship between return streams. They focus on differences between developed and emerging markets. Using weekly returns in U.S. dollar for 16 developed markets during January 1973 through mid-June 2009, 13 emerging markets during late January 1989 through July 2008 and 17 emerging markets during July 1995 through mid-June 2009, they find that: Keep Reading

Risk-based Allocation to Frontier Equity Markets

What is the best way to include the least developed (frontier) stock markets for portfolio diversification? In his December 2011 paper entitled “Frontier Markets: Punching Below their Weight? A Risk Parity Perspective on Asset Allocation”, Jorge Chan-Lau compares the diversification effects of frontier markets within a world equity portfolio based on risk parity and market capitalization weighting approaches. Risk parity equalizes risk contributions across equity classes by assigning the same risk budget to each asset based on co-movement between the asset’s returns and the portfolio returns. The asset allocation comparison assumes five major equity classes: U.S., European including the UK, East Asia and Far East, emerging markets and frontier markets. Co-movement of asset and portfolio returns derive from weekly return measurements over five-year rolling historical windows. Using weekly returns in U.S. dollars for each equity class based on corresponding Morgan Stanley Capital Indexes during June 2002 through November 2011, he finds that: Keep Reading

Stocks versus Bonds as Investment Horizon Lengthens

Should investors believe in the superiority of stocks for the long run and bonds for the short run? In his December 2011 paper entitled “Stocks, Bonds, Risk, and the Holding Period: An International Perspective”, Javier Estrada examines how the absolute and relative risks of stocks and bonds evolve as investment horizon grows (time diversification). Considering both annual and cumulative returns and various measures of variability/risk, he focuses on the question of whether stocks become less risky than bonds for long holding periods. Using annual total returns for stocks and bonds in 19 countries during 1900 through 2009, he finds that: Keep Reading

Alpha in Emerging Markets?

Are the least developed markets also the least efficient, and therefore the best places to look for alpha? Two recent papers address this question for large, sophisticated investors (institutional funds). In the October 2011 version of their paper entitled “Does Active Management Pay? New International Evidence”, Alexander Dyck, Karl Lins and Lukasz Pomorski examine the performance of the passive and active equity segments of large pension plans allocated to U.S., developed Europe, Australasia and Far East (EAFE) and emerging markets. In the November 2011 version of his paper entitled “Is There Any Alpha in Institutional Emerging Market Equity Funds?”, Wenling Lin examines the performance of institutional emerging market fund managers. Using data from the 1990s and 2000s, they find that: Keep Reading

Frontier Market Costs and Benefits

Do relatively high trading frictions in the least developed equity markets offset associated diversification benefits? In the October 2011 version of their paper entitled “Frontier Market Diversification and Transaction Costs”, Ben Marshall, Nhut Nguyen and Nuttawat Visaltanachoti examine this trade-off in 19 frontier stock markets (Argentina, Bahrain, Bulgaria, Croatia, Estonia, Jordan, Kuwait, Lebanon, Lithuania, Oman, Pakistan, Qatar, Romania, Serbia, Slovenia, Sri Lanka, the United Arab Emirates, Ukraine and Vietnam). They first calculate each month a market capitalization-weighted stock index for each country and then combine country indexes to calculate each month both value-weighted and equal-weighted frontier market indexes. They measure trading frictions such as effective spread, quoted spread and price impact based on monthly averages from high-frequency tick data. Using monthly returns and tick-by-tick trading data for frontier market stocks starting as early as June 2002 for six countries and later for others through 2010, along with contemporaneous benchmark index data, they find that: Keep Reading

The Worldwide Equity Risk Premium

What is the state of the equity risk premium across global markets? In the October 2011 version of their paper entitled “Equity Premia Around the World”, Elroy Dimson, Paul Marsh, and Mike Staunton update their estimates of equity risk premiums for 19 country markets and a worldwide aggregate relative to both short-term government bills and long-term government bonds over a period of 111 years. They report local currency and dollar-based real returns and the historical equity premium for each country, and they decompose the premium into dividends, dividend growth, multiple expansion and change in real exchange rate. All aggregates are value-weighted. Using stock, bond, bill, inflation and currency returns for the period 1900 through 2010, they find that: Keep Reading

Equity Risk Premium Book Learning

What do leading textbooks have to say about the excess return you got, should expect, should require or should infer from the market for taking the risk of owning stocks? In the July 2011 version of his paper entitled “The Equity Premium in 150 Textbooks”, Pablo Fernandez reviews definitions and values of the equity risk premium offered in 150 finance and valuation textbooks published from 1979 to 2009. Based on this review, he finds that: Keep Reading

Notes on Variability of Stock Market Returns

How should the variability of stock market returns shape the outlooks of short-term traders and long-term investors? How strong is the tailwind of the general drift upward in stock prices? How powerful is the turbulence of variability? Does the tailwind ever overpower the turbulence? Using weekly closes for the S&P 500 Index during for January 1950 through May 2011 (3,204 weeks or about 61 years), we find that: Keep Reading

2011 Country Equity Risk Premiums from Academia and Practitioners

What are the current academic and practitioner estimates of the annual premiums over the risk-free rate demanded for each country by equity investors. In their April 2011 paper entitled “Market Risk Premium Used in 56 countries in 2011: A Survey with 6,014 Answers”, Pablo Fernandez, Javier Aguirreamalloa and Luis Corres summarize the results of a March-April 2011 email survey soliciting the Market Risk Premium (MRP) used “to calculate the required return to equity in different countries.” Based on 1,562/1,462/850 specific responses to the question from companies/analysts/professors, respectively, around the world, they find that: Keep Reading

The 2011 U.S. Equity Risk Premiums from Academia and Practitioners

What are the current academic and practitioner estimates of the annual premium over the risk-free rate demanded by investors in U.S. equity. How has that estimate changed over the past year? In their April 2011 paper entitled “US Market Risk Premium used in 2011 by Professors, Analysts and Companies: A Survey with 5.731 Answers”, Pablo Fernandez, Javier Aguirreamalloa and Luis Corres summarize the results of a March-April 2011 email survey soliciting the premium “that companies, analysts and professors use to calculate the required return to equity” (Market Risk Premium) for the U.S. in 2011. Based on 1,439/1,397/823 specific responses to the question from companies/analysts/professors, respectively, around the world, they find that: Keep Reading

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