I’m having trouble making the connection between estimating ERP & estimating Required Return. When I think about them in isolation, I understand the concept and the calculations. What I’m having difficulty with is bringing the 2 together… The book states there are 2 types / 4 methods of estimating the ERP. 1. Historical 2. Forward Looking a) Gordon Growth Model b) Macroeconomic c) Survey Then the book goes onto explain different ways of estimating the Required Return: 1. CAPM (RF + Beta x ERP) 2. Multifactor Models a) Fama-French b) Pastor-Stambaugh (Fama-French + Liquidity factor) c) Macroeconomic Multifactor d) Statistical factor Models 3. Build-Up Method (RF + ERP + Size Prem + Company Specific Prem) So when or how does one use the different ways of estimating ERP in conjunction with calcluating Expected Return? I interpretted ERP as a variable that goes into any of these Required Return formulas but I don’t see how/where it would go besides maybe CAPM & the Build Up Method, which leads me to my second question… Is ERP now synonymous with MRP? I’m always accustomed to seeing “market risk premium” in the CAPM formula but now I see ERP in the CAPM formula above (as per Schweser bk 3, pg 44). Or simply put, what is the difference between ERP & MRP? I’m concerned that on exam day, you may be given both and I’m not sure which to use for say, CAPM… Thanks in advance
ERP is the excess return that you would expect from investing in equities in general rather than the risk free asset. hence it is the compensation for bearing incremental risk. you could also say that the risk of equity investments is a priced risk that offers compensation in the form of extra returns (ERP). different stocks will have different systematic risk and hence varying exposures (sensitivity or beta) to the equity risk factor. this difference in risk exposure is captured by “adjusting” the risk premium that an investor in a particular stock would require. this adjustment is through different betas for different systematic risk profiles. the required return on a stock is therefore the risk free rate plus the ERP adjusted for its systematic risk (hence ERP x Beta). MRP is the risk premium for investing in the theoretical market portfolio of all risky assets. Since in practice a stock index is generally used as a proxy for the market portfolio, the risk premium is referred to as ERP.
Let’s take the CAPM formula (but this can be applied to all the models really), which is r = risk-free rate + Beta*(return of mkt portfolio - risk-free rate) Your market risk premium is the term: return of market portfolio - risk-free rate. Like mentioned above, it is the return in addition to the risk-free rate you’d expect to earn. If bonds yield 4% and the return of the S&P 500 = 10%, your market risk premium is 6%. The equity risk premium, term r above, reflects the return of a particular security AS COMPARED TO the market portfolio. - If the beta of that security is less than one, that means the security is less volatile than the market portfolio and you will expect a return somewhere between the risk-free rate and the rate of return on the market portfolio. - If the beta is equal to one, the security is as volatile as the market portfolio and you would expect to earn the return of the market portfolio. - If beta is greater than 1, your security is more volatile than the market portfolio and you would expect a return greater than that of the market portfolio.
Thank you for the replies. My logic was… Market risk premium is the return one would expect to earn in the market portfolio over the risk-free rate. Equity risk premium is the premium one would expect to earn on that PARTICULAR equity, and given its systematic risk, one must ADJUST this premium by BETA. THEREFORE, ERP = MRP x BETA So why does CAPM formula show E® = Rf + B x ERP - hasn’t the ERP already been adjusted for Beta? I guess ERP and MRP are being used interchangeably and it’s really just describing which risk premium we are dealing with? In the context of the market portfolio, it’s the MRP, in the context of equities, it’s ERP. But regardless, both need to be “adjusted” for systematic risk - it just so happens to be the case in the market portfolio, Beta = 1, therefore MRP x Beta = MRP
Also, I just want to make sure on Exam Day, if you are asked to calculate E® using CAPM, and say the information available are: RF, Beta, ERP, and MRP. Which would you use? Would it be… RF + Beta (MRP) or RF + Beta (ERP) or RF + ERP
You’re basically right. Think about it like this: ERP = E® - Rf In the CAPM formula above, just move Rf to the other side of the equation and you’ll have ERP = Beta * MRP. And no, ERP and MRP are not the same thing. I think you’re overanalyzing it. The market portfolio is a reference point that one uses to calculate E®. If it helps you think about it, the market portfolio has a Beta of 1 for its given level of return. Using the given beta of the stock, you compare that to the market portfolio and figure out what your E®.
Expected Return is equivalent to Required Return assuming equilibrium (as in the CAPM model). This is explained in a footnote to the CFAI chapter “Return concepts”
ramdabom Wrote: ------------------------------------------------------- > Expected Return is equivalent to Required Return > assuming equilibrium (as in the CAPM model). This > is explained in a footnote to the CFAI chapter > “Return concepts” I understand that E® and Required Return are equivalent. The question is regarding how estimates of Equity Risk Premium (ERP) are used in the different E® models.