Can we have negative market risk premium? What does that imply?

This is post meant for all finance guys. First let us get basics correct.What do you mean by market risk premium? It simply means the excess returns over the risk free rate that is expected on his investment in market by the investor because of the risk he undertakes. Next is how do we calculate this risk premium? The most commonly used method is to use historical data. We calculate average return on the market and subtract average return of risk-free bonds for the same period to determine market risk premium. So in normal scenario we assume that at going concern the future market risk premium would be same as the past.Now the problem has arisen because of the current financial crises which has led to situation that long term risk free bonds have yielded more than the market during the same period. So if we continue to use this method then we would have negative market risk premium.

I know many of us would have at first instance not agreed to negative market risk premium. Does this actually make sense or method needs to be modified? Let us consider the investment with positive beta in which case cost of equity would become less than risk free rate. So it implies that company would have to pay its shareholders less than risk free rate!! Then instantaneously most of us would suggest that any sane person would sell off his shares and rather invest at risk free rate. This is what happens at outbreak of financial crisis.Investors withdraw the money from stock market and markets tumbled. People invest this money in the bonds of the banks which are considered to be risk free. Under normal circumstances, Banks would cut the risk free rate with huge inflow of capital. This will continue till market risk premium turns positive. Thus for short time market risk premium can be negative but over longer horizon it would always remain positive.

But is this what happen in current financial crisis? In that sense current crisis in US was quite unique due to high leverage in the economy.First of all risk free rate i.e. interest rate in US(if you still consider it to be risk free) were already very low which implied lower deposits with the banks. Second the securitization had created system which was highly leveraged i.e. in simple words people consuming more than money they held. It worked fine till leverage became so high that financial institution itself defaulted. This broke the chain which circulated money in economy. People withdrew money from stock,bond markets but unlike other crisis instead of depositing it with bank they needed them for their consumption. So banks faced liquidity crunch and their investments weren't yielding the expected returns due to fall of stock market. Rate were cut to almost zero but market returns remained negative.Thus we never reached a situation wherein market risk premium became positive. At that point cost of equity was negative which implied that investor expects nothing as return in fact expects to pay to get invested. This is what US government did by means of bail out package wherein it bought stakes in Citibank and others.They enhanced liquidity in system and tried to reinstate confidence in market so that the expected market returns become higher than risk free rate leading to positive market risk premium.

In nutshell market risk premium has to be always positive and if turns negative then steps are taken to make it positive. In other words for the survival of the economy expectation from the market should be positive at any point in time. Long term negative market risk premium i.e. negative market expectation indicates failure of the economy.

I have done quite complex analysis and have written complex blog about the current crisis. I hope it makes sense.

8 comments:

Sumit said...

Good one :) You know what is the advantage of doing an MBA. You can understand all this ;)

ranji said...

interesting!!

Unknown said...

What about a long bear market for equities such as Japan? If the stock maket is falling for years then the equity risk premium is negative regardless of how low interest rates fall (since rates are bounded at zero)?

Anonymous said...

Lots of the information provided by you was probably imparted by fools w/a vested interest.Risk premium is so arbitrary,and spoonfeed to business students by wallstreet bozos greedy intentions. I too learnt this stuff in the Notre Dame MBA program.Especially since it is a mid-west program where most of the 'silly' market concepts were concieved. Yup, UofC where the equilibrium market fools studied.Especially, my favorite Myron Scholes of LTCM.Basically, the current crisis has forced financial experts(fortune tellers/snake oil salesmen)to eat their theories and lies. Shows us the models/theorys sold to us over the past 30 years are bogus. You have to be very simple-minded and arrogant to think you can model capital markets to the degree they claimed to have reached. But yes CAPM basically introduced the risk-free rate as a way to back into market premiums, really only helping those who did not already have a God-Given financial common sense understanding. The financial fortune tellers(greedy)are the main reason for the current economic suffering of the innocent.But they were sinful,money and power hungry!So basically recent negative market risk premiums have been very helpful in discrediting the ridiculous financial theories posited by the selfish(the ayn rand beleivers not the bible beleivers).Only fools don't know that 'black swans' exist,and that unknowns,once thought impossible,have always shocked in all domains in all periods of time.The most foolish(or most money hungry)-the Myron Scholes,Prestigious academia, Wallstreet thought their models could guide in realities/worlds we are so far from understanding. I warms my heart and soul to see some people expend their energy on positive pursuits,especially with all the sinful,evil temptations.Remember to look at the forest and not just the tree. Don't drink always drink the kool-aid. It is important to resist becoming a reservior of teaching, without ever THINKING a thought of your own. Some fortune tellers will look back realizing they sold negative real returns to surplus units. - risk premiums expose a system where investing provided unfavorable economic benefit to the masses.It has allowed the greedy to steal from honest surplus units.U,learn more by reading fiction, philosphy, history,etc.Find yourself,and realzie that CAPM stuff (lots of other stuff too)is junk. Research Long-Term Capital Management.I love the word research by the way."Re" "Search". What are ppl searching for that some already know?CAPM has too many assumptions,but nearly EVERYTHING is based on assumptions/belief. They did not ever THINK or LEARN(or did but were greedy).So yes negative market risk premiums imply that some are not as smart as they pretended to be.Many who thought they were the smartest and understood now realize, if their ego allows, this is not the case. But this or some form of this is to many egotists the final blow to identity in this test we call life.God Bless.Continue to expend energy on the positive, like you have tried.Just consider refocusing some energy. You will become a more enlightened person and richer(in both senses.Life is what you make it-it is energy manifested.Choose your focus carefully. Remember Einstein "re" "searched"(energy) his entire life only to finally realize the only provable is that you cannot prove non-existence. This is the key to life! Think about the implications. I can tell you are motivated to learn(hopefully for the right reasons), but you need to take a step back. Look at the big picture. Step outside the box of manufactured consent. Grow! My child, a few years back, would respond with 168 when I challenged him to think of the largest number.Baseball games: "must be 168 people here", "168 seconds in life".Expand your conscienceness-think,learn,grow!don't learn, think, stay.Thought and thought to define wealth. My definition is suplus retained. Has universal application with proper thought and extrapolation. May peace be with you, Wealthy Protector PS. Don't be a sheeple!

Anonymous said...

Uncertainty exists only ex-ante. Risk exists if and only if uncertainty exist. Ex post uncertainty cannot exits. Ex post is deterministic since we know what happen, what was realized. Therefore risk premia cannot be measured ex post (as you all suggest). Risk premia is only ex ante, forward looking, and can never be measured ex post. It's the same word as hope.
PS: there are two categories of people in this world.
1. Those who didn't go to school
2. Those who did but didn't understand anything

Nirav Kamdar said...

No one is questioning that risk premium is forward looking. In fact thats same idea first part of blog conveys that it is expected returns for the risk being undertaken. Now the question is how do u measure risk? The methods primarily people use take past experience to measure the risk premium or some simulations which again are created based on past. Is this right method ? Certainly no. But then is there any better method available which anyone can suggest? Due to non availability of options people rely on past experiences of risk undertaken and quantify the same.It is based on the assumption that past indicates future which in your word is hope. I would like you to enlighten us with your idea of measuring uncertainty/risk which is ex ante and if you have any, we would certainly respect you but otherwise no point criticizing others who are hoping on some data point when you yourself have nothing to contribute.
In fact one must have cognizance that most human brain also takes decision based on its past experiences and that can not be changed easily.Crisis reiterates that one must not only rely on past fully and must acknowledge limitation of this risk premium method of calculation. Models are just one of the inputs in decision making. Everything said and done I still believe its not possible to completely abandon CAPM.

Seb said...

While I don't deny it is possible to explain ex-post negative risk premium, I still don't understand how it can makes sense economically: if the market risk premium ( E(Rm) - Rf in CAPM)is positive, it means that investors demand an excess return over the risk-free rate when they invest in stocks (because of the higher perceived risk in stocks). Then, a negative risk premium would imply that investors are willing to get a lower return than the risk-free rate (implying that sovereign bonds are then considered more risky than stocks).
If that is the case, you'll get a paradox if you compute risk premia by using historical data, i.e. when stocks crash you will get a negative risk premium. But investors are actually being more risk-averse and should demand a higher risk premium.
My guess is that working on historical data is probably the wrong method (although the easiest one): in CAPM, risk premium is
E(Rm) - Rf, not Rm - Rf.
It seems to me that it is not entirely correct to assume that investors are completely driven by past performance to assess expected market return (i.e. to assule that E(Rm)=Rm).
Has anyone tried for example to use option princing to get an implied market return?

Unknown said...

Nicely written. But whats the solution for this??? I mean how you can make it positive or in other words normalize it?