Copyright 2001. John R. Graham and Campbell R. Harvey. 1 Expectations of Equity Risk Premia,...

Copyright 2001. John R. Graham and Campbell R. Harvey.

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Expectations of Expectations of Equity Risk Premia, Volatility, and Asymmetry: Equity Risk Premia, Volatility, and Asymmetry:

From a Corporate Finance PerspectiveFrom a Corporate Finance Perspective

John R. GrahamDuke University, Durham, NC USA

Campbell R. HarveyDuke University, Durham, NC USA

National Bureau of Economic Research, Cambridge, MA USA http://www.duke.edu/~charvey

AIMR Equity Risk Premium ForumNew York, NY

November 8, 2001


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Graham/Harvey: Expectations of Risk Premia

Measuring CFO Market Expectations

• Survey CFOs every quarter• Q2 2000 through Q3 2001 (six quarters)

• ~200 responses per quarter (1,200 total obs.)

• Why CFOs? – We know they use CAPM from previous surveys– Hence, they have thought hard about risk premium– Should not be biased the way that analyst forecasts

might be


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Across Time and Different Horizons

• 10-year risk premium around 4% and stable whereas 1-year risk premium quite variable

0

1

2

3

4

5

6-Jun-00 7-Sep-00 4-Dec-00 12-Mar-01 7-Jun-01 10-Sep-01

0

1

2

3

4

5

6-Jun-00 7-Sep-00 4-Dec-00 12-Mar-01 7-Jun-01 10-Sep-01

10-year premium 1-year premium


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Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Premia

• 1-year risk premium sensitive to past returns

y = 0.1096x + 2.3068

R2 = 0.7141

0

1

2

3

4

5

-20 -15 -10 -5 0 5 10

Past quarters' return

One

-yea

r pr

emiu

m


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Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Premia

• 10-year risk premium not sensitive

y = 0.0179x + 4.3469

R2 = 0.1529

0

1

2

3

4

5

-20 -15 -10 -5 0 5 10

Past quarters' return

One

-yea

r pr

emiu

m


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Measuring Volatility

• Able to deduce each respondent’s probability distribution– “High range: During the next year, there is a 1-in-10

chance the S&P 500 return will be higher than _____%”

– “Low range: During the next year, there is a 1-in-10 chance the S&P 500 return will be lower than ______%”


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Measuring Volatility

• Market volatility is

average of individual volatilities (average volatility)

+ dispersion of risk premium forecasts (disagreement)

• We consider both components


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Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility

• Average volatility (1-year) weakly related to past returns

y = -0.0452x + 6.4722

R2 = 0.1282

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3

4

5

6

7

8

-20 -15 -10 -5 0 5 10

Past quarter's return

Ave

rage

vol

atil

ity


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Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility

• Disagreement (1-year) strongly related to past returns

y = -0.153x + 4.3658

R2 = 0.7298

2

3

4

5

6

7

8

-20 -15 -10 -5 0 5 10


Dis

agre

emen

t vo

lati

lity


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Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Skewness

• Average skewness (1-year) strongly related to past returns

y = 0.1438x - 0.8105

R2 = 0.7636

-5

-4

-3

-2

-1

0

1

2

3

-20 -15 -10 -5 0 5 10


Ave

rage

asy

mm

etry


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Graham/Harvey: Expectations of Risk Premia Expected Premia and Expected Volatility

• Average volatility (1-year) negatively related to expected returns

y = -0.5178x + 5.2945

R2 = 0.2538

0

1

2

3

4

5

2 3 4 5 6 7 8

Average volatility

Exp

ecte

d pr

emia


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• Disagreement volatility (1-year) strongly negatively related to expected returns

y = -0.6977x + 5.341

R2 = 0.9283

0

1

2

3

4

5

2 3 4 5 6 7 8

Disagreement volatility

Exp

ecte

d pr

emia


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• Disagreement volatility (10-year) strongly positively related to expected returns

y = 0.9949x + 1.4616

R2 = 0.6679

0

1

2

3

4

5

2 3 4 5 6 7 8

Disagreement volatility

Exp

ecte

d pr

emia


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Impact of September 11, 2001

Pre-Sept. 11 Post-Sept. 111-year premium

Mean premium 0.05 -0.70Average volatility 6.79 9.76Disagreement volatility 6.61 7.86

10-year premium

Mean premium 3.63 4.82Disagreement volatility 2.36 3.03Observations 127 33


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What have we learned?

• Forecasts impacted by past returns (expectational momentum)

• Leverage effect validated with new expectational data

• Individual volatilities seem low

• Positive relation between risk and expected return - only at longer horizons


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Outstanding issues

• 1-year forecasts unlikely used as the “hurdle rate” for 1-year project evaluation

• Difference between what CFOs think will happen to the market and their internal hurdle rates


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Outstanding issues

• Hurdle rates and risk premium:– Premium should be high given that we are in

recession– Higher hurdle rates are often used which proxy for

• Scarcity of management time

• Financial flexibility options

• Option to wait


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Next phase

• Individual CFO interviews:– 25 interview scheduled for first week in December– Will ask them to explain the difference between

their market forecast and their internal hurdle rates


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Appendix

• Market volatility

Var[r]= E[Var(r|Z)] + Var(E[r|Z)]

average vol. disagreement vol.

• Individual volatilities (Davidson and Cooper)

Variance = ([r(0.90) - r(0.10)]/2.65)2


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Appendix

0.00

0.05

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0.15

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0.25

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0.35

0.40

< -20

-18

-16

-14

-12

-10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 20

more

Proportion

1-year premiumSeptember 10, 2001


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Appendix

0.00

0.05

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0.15

0.20

0.25

0.30

0.35

0.40

< -20

-18

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-14

-12

-10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 20

more

Proportion

10-year premiumSeptember 10, 2001


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Appendix

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

<3 6 9 12 15 18 20 >20

Proportion

1-year individual volatilitiesSeptember 10, 2001


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Appendix

0.00

0.05

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0.20

0.25

0.30

0.35

0.40

0.45

-20 -15 -10 -5 0 5 10 15 20 >20

Proportion

1-year individual skewnessSeptember 10, 2001

Copyright 2001. John R. Graham and Campbell R. Harvey. 1 Expectations of Equity Risk Premia,...

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