Experiential Learning : Fallacies of Human Mind - I

After having spent significant time of my short career on the quantitative aspects; I was intrigued by behavioral science and so sometime a year back I took course by Prof. Dan Ariely on this subject. I found course to be quite insightful and practical. Since then I have been consciously trying to recognize and overcome common behavioral mistake in my decision making process. I must confess that my success ratio is pathetic but now I am at least aware of my mistakes. As part of my experiential series, I would like to introduce few concepts I learnt during the course with examples from non financial world and then elaborate on my experience from the investment side.

‘Human mind likes to select default option and therefore decision making tends to be more default. This issue is exacerbated as complexity (option) increases. Default option is not always bad or always good. It is just an option which is easy for our brain to select ’. I have always enjoyed solving complex problems and therefore I took time to accept this. But now I am able to appreciate the same over period of time. Marketers exploit this behavior to make us buy stuff which they want us to buy. For example cell phone manufacturer sells phones under different brand name with almost similar specs at similar price that it is difficult for buyer to make rational decision. In such cases, instead of buying based on ones need, buyer tends to buy stuff that is sold to him. This is because mind selects default option instead of choosing right one from the many available options.

On the investment side, this problem is even more difficult to recognize. We spent so much time on selecting right stock/investment so as to beat the market returns but once the investment is made then our behavior moves to default option. Though every trader would agree that once the position is marked to market on previous day, holding on to the existing position is similar to taking fresh position but very few traders put that to practice. We have tendency to continue with default option that is to hold on to existing position. That's the reason of the industry practice of having stop loss; to force the trader to think of his existing position. So many times in past I have exhibited such default behavior while trading and in fact still continue to do. For me, ability to exit an existing position is still a challenge which I continue to face but now I am aware of it and working on it.

This concept applies to the quant world also. Industry still continues to use archaic models that assume normal distribution of returns irrespective of market behavior since it is more familiar to them and hence is their default behavior. VaR continues to dominate risk management world rather than mix of complex stress scenarios which can quantify tail risk also. Management still needs one simple risk metric even though it may be inadequate under stress scenarios. Only change post crisis is recognition that these models may fail. In era of negative interest rate, CAPM still continues to be base model. Inspite of ballooning deficit, US still remains standard for risk free rate. And the list is endless…

This concept also applies to every human being when s/he makes the important decisions of their life. If I look back today to see how the most important decisions of my life were made then I feel lot of them have been influenced by this default option especially when stakes were high. Just take few minutes and ponder how you made your most important decisions of your life. Most of us must have been influenced by this default option. I have currently no standard method or process which helps me avoid this pit fall except that I now recognize the issue. My way of overcoming it is to reduce the available options and then consider default option as unviable and then let my grey cells identify second best option. Then problem is reduced to evaluation between default and second best option just selected. Still it continues to be challenge to ensure rational decision making. Any suggestions to handle the issue better?

New India : Post Demonetization ?

Whether you like him or hate him, you have to laud Mr Modi for his courage to take bold decision that can disrupt the society/nation. There have been many business leaders in recent times who have adopted disruption as model to change the industry dynamics but very political leader have adopted such model for governance.  It is double edged sword and not many are willing to risk so much when the stakes are so high.  Before you carry any impression of this post being the diatribe by one of his staunch followers, I would highlight that I only acknowledged his courage to take such bold decisions. Whether the decision is good or bad that time will only tell us but it will definitely have far reaching impact on our society.  I have attempted to put across my objective assessment of the event and its possible consequences without taking ‘for or against’ view. 

East Asian crisis is said to have imprinted financial crisis fear in minds of the people living in those countries at that time and hence for years later they have preferred to save rather than spend unlike their western counterparts. This fear led these countries to maintain much higher reserves as safety net for any future crisis. Similarly in India, high inflation observed in last decade has led to erosion of wealth for savers in India and this has given rise to new generation of spenders. I believe demonetization has potential to have such behavioral change on our society and therefore have tried to focus such long term effect rather than taking myopic view that focuses only on immediate consequences.

Greed and fear are two emotions which determine large part of people’s behavior when it relates to money management.  Current demonetization of high value currency notes will immediately alter the current equilibrium of these emotions in people. People at large seem to have overcome the fear of corruption/black money and it is the greed that seems to be driving their behavior towards current form of society. Years of inaction against corrupts/black money hoarders has reinforced the moral hazard.  Like all moral hazard problem, everyone knows it exists but don’t know how to avoid the same. Mr Modi seems to believe that his decision will end this moral hazard issue in the society. He is trying to make it difficult for corrupt people/black money hoarders to avoid erosion in their wealth by his policy decision. Hypothesis here could be that the pain such people will go through while losing their wealth which they have always believed to be theirs would be immense and would prevent them from hoarding black money in future. The consequences they will face will serve as deterrent for others in the society to commit on this path of corruption & black money. Also people who have paid their taxes on time will get pleasure of seeing the pain of others who don’t fall in their group and would reinforce their FEAR in future. (In fact it is this pleasure which led to initial positive assessment of his decision). If this succeeds then we may see an end of parallel black economy that has existed for years. It would make it difficult to fund terrorism, bribe officials etc since source & use of funds can be known easily. Already news have been flashing of the difficulties naxals are facing to exchange their loot and they may also see erosion in their wealth. Here FEAR is expected to bring about positive change in people.

Let’s try to take contrarian view about the same event. The high valued notes earned by the people have suddenly become worthless instills FEAR about monetary currency. The current monetary system exists mainly because of the people faith that it will be honored without much hassle.( Of course in current form, one can deposit or exchange currency notes up to certain limit but it is certainly not hassle free.) If people start having doubts about high value currency notes then in future they will not like to accept it or keep it as saving instrument. Would they then prefer gold over them in future since in our society gold’s acceptance has never been questioned yet? Further its global acceptance provides additional comfort for liquidation and removes one’s dependency on nation central bank. This can lead to situation wherein savings would not get channelized into useful development but into gold hoarding. Of course government and central bank may have other means to change this behavior but it would take years to acknowledge and act on the same.  Lot of black money hoarders were believed to have rushed to buy gold, USD post demonetization announcement. Of course they intended to convert black money into gold for future use. But will this immediate gold buying end once these two months are over? Answer could be NO!!! Government would like to believe it will create enough incentive to move people to digital currency. Phew, new disruption model for country where literacy rates are so low; where gullible people have been duped so many times in past that they don’t even trust the banks.

Black money incentives risk taking, discretionary spending among the people. Demonetization will lead to overall decrease in wealth in the society as such and would either strengthen central government or central bank balance sheet. Even if government increases its expenditure, it will take time for this wealth to be accumulated by the society large. Now what do we expect from such society which witnesses mass wealth (legal/illegal) destruction due to act of government? FEAR ? People would spend less, less corporate gains, lower number of new jobs etc. Coupled this with highest population in age of 20-30 years, global slowdown & protectionism and rising terrorism imagine the potential social unrest it can create in huge nation like ours.  In both above cases, FEAR seems to have negative consequences for the society.

The actual consequence of this event may lie in between both the extremes described above.  It is very difficult to gauge people’s behavior and predict the future especially when population is more than billion. But it is certainly one of the exciting times to be in India to experience the same.  Government and its policies will definitely have key role in influencing people behavior. But I firmly believe it is us and our behavior that will shape up the future of this society and government response will be guided by them. So let’s keep our emotions in check; objectively assess situation with open mind post immediate fallout before forming any firm opinion about the event. 

Land Bank Story

Its been long break for me from blogging but with new year am back in action. Its normal tendency to ensure that you fulfil your New Year resolution atleast in first month of the year and thats what this blog signifies. 2010 has certainly been the year I would like to forget except for change of job and role at fag end of the year which has been positive event in my life. I think its enough update about me and I don’t think it’s interesting enough to discuss and the waste space on my blogs.

The title can mislead the people who have not been following the markets. So let get it clear for such people that I am not sharing any story about bank nor land but its buzz word of 2010. Its story which has got my grey cells thinking for quite some time. Story that once again exhibits conflict between my theoretical understanding and empirical evidence. So I thought to write about it and get the views of others to clear my doubts.

Valuation has always been tricky subject to handle and assumptions for the same vary from analyst to analyst. So there is not point on arguing assumptions at any point in time when it comes to valuation. But very few times I have seen disagreement on the methods of valuation or on fundamental concepts. One of such concepts is that valuation is typically done on going concern basis with few exceptions. Exceptions are cases where companies is believed to liquidate or similar cases. But is this being reflected in the market is my question? One can easily check the stocks in market and you will find really high valuations for certain companies which are even loss making. The price commanded by them in the market is high as 100 times its EPS. So I undertook its analysis and found one common buzz word associated with them was “Land Bank” and I realized the difference is because I was doing simple DCF on going concern assumption whereas market price was factoring in the price of its assets. So is this right method since the market suggests so? Is it temporary factor and market will correct in future? But price pattern doesn’t suggest so.

To understand the issue let’s take case of Bombay Dyeing which is most simple one. The company has debt-equity ratio of 9.23, EPS growth of -109.46% but currently commands PE of 115, way above the industry average. The reason is huge land bank available with the company in prime areas of Mumbai. The company PE has been in this range for quite some time due to the speculation of company’s plan to develop real estate. So market valuation has factored in current market price of the land or future cash flows it would generate with the real estate. I would have been comfortable if it was second reason since it follows with going concern assumption. But then would you factor such high valuation for the company who is entering real estate for the first time in life and whose expertise is in textile. Also the risk associated with such project is way high to command this PE. Further if company commands this PE based on the market value of its land then in the downturn why was the stock not punished for low market value of its so called land bank since the news of them developing real estate goes way back to 2008. Why market valued it as textile player then? Should we analyze these companies with two business units and do DCF for both of them? Or should we do DCF for its textile business and add market value of land? If this is market practice why don’t we follow it for all similar stocks? Further this concept inherently is accepting the concepts of mark to market for all the asset class which has been issue of contention for quite some time. The land is illiquid asset and to which level can its market value be factored in our assumptions. Would the investors in this stock continue to be the investor if one time unlocking of value for its land bank is done? Who would be buyers at that point in time? Further company being textile company can still use its proceeds to decrease it debt and use remaining for the future capex in which case investors looking for one time gain would not receive any additional payout. So in this case also it is going to be company capability in textile business that one needs to analyze from long term perspective. All this doesn’t justify to me this high PE for the company given that they have not done well in textiles recently. This is just one of the examples; similar cases exist for Bayer Cropscience, Century textiles, golden tobacco etc. These are questions I am pondering for quite some time. I understand analyst once believes that asset value is realizable and then he factors the same in price so this rule cannot be generic. But then once value is realized the question still exists is where the proceeds would be utilized? Would it be utilized in development of real estate or textile business? Also till the value is realized its only notional value and this concept is used when we value investment companies who might have equities which are of high market value of its book. Otherwise small investment companies like Pioneer investment must command much higher price since it has securities worth more than its market cap at current price and further they are much more liquid. Same is true with other such investment companies.

So what was my intention of the blog? It was not to highlight case of Bombay Dyeing but rather at concept level I wanted to discuss such scenarios. Especially my view is land value at current market price cannot be factored in fully in calculation since it’s not realizable. Further the company’s plan of using the proceeds is very important factor along with the company strategic goals. If its land bank which is attractive, I would rather invest in comparable real estate company than such companies or at least compare it with peers in real estate before coming to this decision. Currently I believe analyst have been more speculative and have gone overboard when factoring the value of ‘landbank’ and have not been consistent with the concept or mark to market in all such cases. I might be proven wrong and cases like Bombay Dyeing might prove them correct but valuation like this makes me rethink my basics. Maybe Bombay Dyeing might not have been right example to discuss this given its long history and brand name but cases like it are in plenty and I would certainly like to understand the investors story in such cases that can prove my view incorrect.

No Change in Pricing Strategy Please!!!

After long break I am back to blogging. It has been one full year now after my graduation and I must confess that graph of my intellectual curiosity is exponentially dipping with time. Unlike academic life, Professional life doesn’t give that luxury to experiment, learn & grow. The daily mundane task eats most of the time. But I have somehow continued my habit of reading universities blogs, business magazines etc which have been helpful to stay somewhat abreast with latest studies/researches, news etc.

Few days back I came across very interesting article in recent edition of HBR. Though I hadn’t been the big fan of HBR during MBA days but these days I do glance through the same. As always I found most of the articles uninteresting except one which caught my eyes. I had experienced the same in past one year. I can’t recollect its exact title but it was something like “Why are business leaders not ready to innovate pricing”. During MBA everyone is taught different methods of pricing (cost based, market based, value based etc.). Phew!! One year away from academics really makes it difficult to recollect all the jargons and methodology (Signs of becoming unemployable :( ).But just try your luck to implement one of them in real world and you will face the resistance. The same experience is narrated by the author.

I have read n number of articles and research in recent times on pricing in the recession etc (of course sources includes mother of all gas content Mckinsey & peers) but my success of implementing those or convincing people to do the same in my company is questionable. So why is this resistance? The fact is no one wants to take hard decision. No one wants to lose competitive edge and innovation can never come without risk of failure. Consider for instance IT outsourcing industry which went through the troubled times during recent crisis. Every CEO, CFO in their quarterly results were cautious and have made statements like we are experiencing pricing pressure and it has affected our margins by x basis points. But none of the analysts have asked them what they are doing to counter the same. Every company fears any change in their methodology might cause them to lose customer. But can’t there be win-win situation? There are such methods but companies are just not trying them. Why? Simply because they can get away easily and isn’t the matter of their survival.

Consider other industry where the case is not same-Telecom industry. Tata Teleservices came up with pay per second pricing. Was it good for the industry as such? Perhaps not. Was it good for the company? Questionable. Was it good for the customer? Certainly yes. So what was it that made Tata Teleservices to risk a change in pricing which IT outsourcing industry isn’t ready for? It was question of its existence in competitive market. In absence of any differentiation among players price is final weapon which they had and they used it. I am not here to justify their action or strategy but am providing only the situation when company looks for innovation in pricing.

Other situation when company is ready to experiment with pricing is when there is huge gap with demand and supply and its sellers market. Example of this can be realty pricing in Mumbai wherein developers started charging for built-up and super built up area and then it became norm. But such cases are not going to be more in future given nature of competition that exist today & our integration with global economies.

So what am I trying to suggest by these random examples. Put theory aside. In real world 99% of the company would resist any change in implementation of new pricing methodology until it becomes matter of its survival. This is hard truth. But given such situation arises in your industry would your company be able to suddenly come up with new pricing strategy or just wait for competitor to act and then copy if successful. Which one is good strategy? Latter can also lead to case where no one in industry is ready to risk itself causing industry wide slump (Airline industry). So isn’t it advisable to at least have alternate pricing strategies ready and tested so that it can be implemented any time. Isn’t it good idea to have dedicated team to look at innovative pricing models & be ready with its go to market strategy. I believe some more part of the R&D expense should be spent here. There is enough scope to learn from one industry and replicate in other. Why stick to well defined methodologies learnt in B-school or follow the market leader? Innovation in pricing is need of the hour along with product/service innovation. Corporate world please wake up!!!!

Finance in IT industry

This post is for all the finance graduates who are wondering about opportunities that are present for them in Indian IT industry. There is very less awareness about the roles for finance graduate in IT. It is common perception that only role available is that of business analyst who acts as domain expert for financial sector and plays key link between business and software engineers. This business analyst is expected to work from requirement gathering to testing. But this is just operational role from IT organization perspective. Of course then there are also roles which are present in any company irrespective of the industry like one of financial planning and budgeting etc. But other than these there are other exciting and upcoming areas which I guess should interest most of the finance guys and which are present in most of the companies which have attained certain IT maturity.I intend to just highlight this broad area in my post.

Assuming a finance graduate joins an investment bank/fund house; his success would depend on his ability to manage his portfolio of assets such that he provides higher returns to his clients. This requires skill-set that enables him to perform valuation of different available assets and which I believe is the one of the most difficult part of his job. So is there any opportunity for the such person in IT industry ? Is there anything which could be as challenging as this? And my answer is yes. In fact gravity of problem increases than in financial sector. There the aim is to do valuation of asset and manage portfolio of assets which are mostly tangible and quantifiable but in case of IT one must do valuation of services and manage portfolio of applications. This is certainly more difficult since its intangible. If asked to draw parallel with equity then imagine yourself trying to value equity offered by newly formed company in some very new industry with no existing comparables. Imagine if someone was asked to value google as company in say 1980’s. Yes now I guess one would understand the gravity of problem trying to value intangible service. So why is it required in IT to do valuation of services? Its answer is very simple: - for its existence. It is very common problem which many CFO and CEO face today. They unable to understand where does the money for IT go? And moreover what tangible benefits does IT provide to the company. If you put in more MBA terms how does IT help in increasing shareholders value? You may like stakeholder instead of shareholder then I am fine with it too!! The problem is more aggravated when IT is horizontal servicing different business units. No business units are able to determine financial gains from IT services and economic downturn like this certainly makes them prune their IT budgets. So it is required to determine value of the IT services. Now the next question is how. This is most difficult since there has not been any Damodaran born in the industry to help them. Though there are certain guidance provided by different governing body but literature and research is much sparse compared to one available with financial sector. So I think this is one of most challenging areas for finance guys with bit of IT knowledge and strong business fundamentals to look forward for in IT industry.

I hope I pointed to some new areas for most of you guys who are not well versed with this industry and an opportunity for 2010 graduates. I know it doesn’t look as sexy as working in investment bank but for someone like me who passed out in 2009 and was forced to join IT industry it looks really exciting. From the day I joined industry my aim was to leverage my finance knowledge and provide new perspective in IT and am atleast satisfied that in my 6-7 months I have been able to research and work on this area. This is how I have made my knowledge relevant to my company and “am trying to create value for shareholder/stakeholders and who knows I may be damodaran in making for this industry." :)

This post is also answer to lot of questions which my friends are trying to figure out like what am I doing in an IT company. In fact one of them was shocked to know that even after MBA Finance I have rejoined IT industry. He glanced at me with a look as if I was black sheep in finance community and must be stripped of my degree. For him it was demeaning of the esoteric financial knowledge by working in an IT company . I hope that this awareness will help me to salvage some pride in eyes of such guys.

Derivatives in IT decision making

Doesn’t topic look strange? Yes I am referring to using derivatives in selecting IT solution. I haven’t got crazy working in IT industry after MBA finance but the fact is it relates. I read an amazing article from an analyst of Forrestor who had proposed this concept and I have highest respect for his knowledge and conceptual clarity of both the worlds – IT and Finance. So the credit for this post goes to him. I am trying in this post to explain my understanding of the report in simple words for benefit of non-IT guys.

Let me start with simple question – what does a business looks for from its IT? I know it may mean different to different businesses but in very crude terms we can say that IT must at very basic level facilitate the business to grow and thereby achieve its objective. Now the question for CIO is when business looks forward to IT for some solution to business problems he needs to select best from variety of alternatives available. This is very subjective since it has to take into consideration variety of constraints like budget, available skill set and future business outlook. But do all the necessary factors are factored in while making such decision? How is the cost-benefit done for each option? More often than not CIO would determine cost of implementation and the value of direct benefits from it and then select one which gives maximum value for given cost which should be within the budget. But is this the best way to take such decision? I will give simple example. Given business problem say introducing online shopping can be solved by solution A and solution B. Cost of solution A is say Rs 1 lakh while of solution B say 1.2 lakh which provides same functionality but with flexibility to add auction feature within a year. Now given above method of decision making CIO would select solution A since there is no way to factor the value of limited (time bounded) flexibility that solution B offers. So here if CIO is able to find the value of flexibility then he can make better decision. Then how to find its value?

The answer to this problem is call option from finance industry. This case is similar to concept of the call option which gives the buyer of the option a right to buy the underlying at strike price before expiry date of the option. Here also solution B offers CIO a right to implement auction functionality at certain determined cost within a year. The call options have value for the right they provide and similarly this flexibility should also have value. Call options price is found using Black Scholes option pricing formula:-

c= s*f(d1) –xe-rt f(d2)
d1={log(s/x) + (r + v2 /2)t}/v*sqrt(t)
d2 = d1 – v*sqrt(t)

where ,
s= price of underlying
x= strike price
r= risk free rate of interest
t= time duration for expiration of option
v = volatility for stock
f= standard normal cumulative distribution function.

We can use same formula to find value of the flexibility to make more informed decision since the concept is same. In our case

c= value of the flexibility provided
s= return on implementation of auction feature
x = cost of implementation of auction feature
t = 1 year here i.e. time available to avail the flexibility
v= volatility of industry can be used to predict volatility of business and hence technology usage.

So using this above option we can find value of this flexibility and that value can be deducted from option B to make it comparable with option A. This would enable better decision making for CIO than obvious methods that are used today. Further it provides him an opportunity to deliberate on future features that might be required and may facilitate him to provide more objective explanation to CFO for budgetary approval of flexible IT solution that may help business in longer term.
I know you may question lot of assumption like that of volatility and usage of normal distribution and most important the assumption made by Black-Scholes in pricing model etc. But this post is meant to bring to your knowledge entire new dimension of using the financial knowledge in IT decision making. We can always debate out the viewpoint and criticize the shortcoming of any model but at same time I think we should appreciate the new perspective.

Skyrocketed SENSEX : A Mirage

This post is meant for the novice investors who would have sudden jump in SENSEX and NIFTY and would have concluded end of the bear market. Suddenly one can see people talking again of SENSEX reaching 20000. Popular TV channels creating the excitement and hype around the frenzy market. At this moment I would like everyone to introspect and understand what has suddenly changed so much that we see such confidence. We must understand what this index numbers suggest.

First let us remove the misconception if anyone has that these numbers are real number. On NSE website one can get following statistics about the equity market:-

Number of trades        29279
Traded Qty. (lakh shares)     84.3
Traded Value (Rs. crores)     170.32

This numbers should ring bell in anyone's mind. They clearly suggest that hardly any trading took place on NSE. Thus the stock prices at end of the day are some random prices which got matched. It might be just one trade which took place at that valuation and subsequently there were no buyers at that price.

Second let's look at other important data about the activities of DII's (domestic institutional investors)

DII trading activity on NSE and BSE in Capital Market Segment(In Rs. Crores)

Category     Date     Buy Value     Sell Value     Net Value
DII     18-May-2009     41.62         50.03         -8.41

This clearly suggests the intention of the institutional buyers. They were invested in the markets during the bear phase and booked profits today i.e. buy at low price and sell at high price.

Now let's look at NSE F&O market statistics

Index Futures and Index Options

Index futures saw a trading volume of Rs.1372.38 crores arising out of 65288 contracts and Index options saw 31003 contracts getting traded at a notional value of Rs.599.21 crores. The total turnover of the Futures & Options segment of the Exchange was around Rs.2599.35 crores.

Options on individual securities

Out of 233 securities, options on 48 underlying securities got traded. The total number of contracts traded was 360 with a notional value of Rs.16.24 crores.

Futures on individual securities

Out of 233 stock futures on 197 underlying securities got traded. The total number of contracts traded was 12467 with a traded value of Rs.611.51 crores.

This data suggest the same thing that hardly any trading took place. But now most important thing to look at is the open interest at end of trading hrs:-

Index Futures

Symbol	Open interest (Qty.) as at end of trading hrs.
NIFTY	39342850
MINIFTY	1268460
BANKNIFTY	961650
CNXIT	8400

Index Options

Symbol	Open interest (Qty.) as at end of trading hrs.
NIFTY	82245650
MINIFTY	10800
BANKNIFTY	8400
CNXIT	0

It is these huge open positions which people are trying to cover up which led to this sudden jump in the market. It was general expectation that people would elect hung house and thus speculators had taken positions in the market accordingly. But with the people mandate for single alliance without support of Left clearly raised hopes for reforms and more possibility of foreign investment pouring in. So in order to avoid huge losses speculators started to cover up positions. These open positions also suggest that such activity can be seen even tomorrow or in near future but this does not indicate any long term trend.

I know many of you would be against entire explanation of mine. You may say that markets are leading indicators and they reflect the future health of the Indian economy. Stable non-Left government indicates possibility of reforms and high growth. However my answer to all this explanation is that nothing has change in the neither global economy nor Indian economy in a day. The impact of the action which we speculate would be taken by government in near future can be seen only after a year or so at earliest. Further the valuation of any company cannot change by more than 30% in a day. The fundamentals haven't changed to that significant level. There is liquidity crunch at global level, less demand and a change in government cannot impact this in a day or a month or so. If we go by theory then the information of change in government is known to everyone and by efficient market hypothesis we cannot make profits because of this publicly know fact.

Thus its right market to sell and book profit or get out of bad investment. That's my advice.

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.