08/04: Current Bond Risk
Category: capital asset pricing
Posted by: Admin
A very smart little assessment of bond risk.
22/03: The ERP and Fear....
Category: capital asset pricing
Posted by: Admin
Professor Aswath Damodaran has had a long interest in and done a good deal of research on the ERP. His thoughts here are worth considering...
Equity Risk Premiums and the Fear of Catastrophe
As many of you already know, I am a little fixated on the equity risk premium. More than any variable, it explains what happens in equity markets both in the short term and the long term. In fact, I have at least a dozen posts over the last year and a half on the evolution of the equity risk premium in the US and globally.
The equity risk premium measures what investors collectively demand as a premium over and above the riskfree rate to invest in equities as a class. In practice, many analysts use historical data to estimate this premium. Thus, if investors have earned 9% on stocks over the last 80 years and 4% on treasury bonds over that same period, the historical premium is 5% and it is also used as the equity risk premium in valuation. My problem with this approach is that it is not only backward looking (you want a premium for the next decade, not the last 8 decades) but yields extremely noisy estimates. On my website, for instance, I estimate the historical risk premium for stocks over treasury bonds from 1928 - 2009 to be 4.29% but I also estimate the standard error in this number to 2.40%.
Equity Risk Premiums and the Fear of Catastrophe
As many of you already know, I am a little fixated on the equity risk premium. More than any variable, it explains what happens in equity markets both in the short term and the long term. In fact, I have at least a dozen posts over the last year and a half on the evolution of the equity risk premium in the US and globally.
The equity risk premium measures what investors collectively demand as a premium over and above the riskfree rate to invest in equities as a class. In practice, many analysts use historical data to estimate this premium. Thus, if investors have earned 9% on stocks over the last 80 years and 4% on treasury bonds over that same period, the historical premium is 5% and it is also used as the equity risk premium in valuation. My problem with this approach is that it is not only backward looking (you want a premium for the next decade, not the last 8 decades) but yields extremely noisy estimates. On my website, for instance, I estimate the historical risk premium for stocks over treasury bonds from 1928 - 2009 to be 4.29% but I also estimate the standard error in this number to 2.40%.
Category: capital asset pricing
Posted by: Admin
This from Eric Falkenstein...
I was an official economist for a while, back at KeyCorp, and would sometimes have to give little presentations on the standard macro variables. I remember once in early 1995 having a little 5 minute presentation to the board of a large hardware supply company (a small 'Home Depot' type chain). About 20 suits in a room, and they were all very interested in where interest rates were going. At that time, rates had rise a lot, the yield curve was steep, and they were very concerned. Now, given they had a lot of fixed rate long term debt, they could lose a lot of money if rates fell (rates fall, bond prices rise, and they were short bonds). If rates fell, their liabilities would go the other way. As rates were moving a lot, they were very concerned.
I told them in general, when the yield curve is really flat, rates tend to fall. They did, but that's not the point. Indeed, I should have told them I have no clue, but I knew they wanted a 'view', and I was trying to be helpful (we were a 'full service' bank). They debated back and forth for 20 minutes, and though I left, I had the sense they kept discussing it. I never found out what they actually did. The point is a large amount of management time was spent discussing something where they had no alpha, no comparative advantage, no value as management. They all assumed markets were 'wrong', so the question to them was clearly which way. If instead they thought bond prices incorporated all available information, they would have chosen a neutral position, say by having floating rate debt (it was feasible to swap into this).
A lot of resources are wasted by people who think it is imprudent to act as if markets are rational. They then basically take random gambles that on average lose money via fees paid on various transactions. Most importantly, they lose their focus on where they conceivably have alpha.
I was an official economist for a while, back at KeyCorp, and would sometimes have to give little presentations on the standard macro variables. I remember once in early 1995 having a little 5 minute presentation to the board of a large hardware supply company (a small 'Home Depot' type chain). About 20 suits in a room, and they were all very interested in where interest rates were going. At that time, rates had rise a lot, the yield curve was steep, and they were very concerned. Now, given they had a lot of fixed rate long term debt, they could lose a lot of money if rates fell (rates fall, bond prices rise, and they were short bonds). If rates fell, their liabilities would go the other way. As rates were moving a lot, they were very concerned.
I told them in general, when the yield curve is really flat, rates tend to fall. They did, but that's not the point. Indeed, I should have told them I have no clue, but I knew they wanted a 'view', and I was trying to be helpful (we were a 'full service' bank). They debated back and forth for 20 minutes, and though I left, I had the sense they kept discussing it. I never found out what they actually did. The point is a large amount of management time was spent discussing something where they had no alpha, no comparative advantage, no value as management. They all assumed markets were 'wrong', so the question to them was clearly which way. If instead they thought bond prices incorporated all available information, they would have chosen a neutral position, say by having floating rate debt (it was feasible to swap into this).
A lot of resources are wasted by people who think it is imprudent to act as if markets are rational. They then basically take random gambles that on average lose money via fees paid on various transactions. Most importantly, they lose their focus on where they conceivably have alpha.
Category: capital asset pricing
Posted by: Admin
From the New Yorker 12th March
IS WARREN BUFFETT CRAZY?
Given the relentless barrage of bad news about the U.S. banking system and the near-constant calls for the government to nationalize the country's biggest banks, you couldn't be faulted for wondering if Warren Buffett had lost his mind when, in a three-hour appearance on CNBC Tuesday, he called this "a great time to be in banking," talked about the massive "earnings power" of banks like Wells Fargo, and said that the government actually doesn't need to supply most banks with "lots of capital."
(Another explanation for Buffett's relatively upbeat forecast was that, in industry parlance, he was just "talking his book," since he has big stakes in banks like Wells Fargo and U.S. Bancorp.) But the truth is that the recent history of U.S. banking suggests there's a chance, at least, that Buffett was right.
IS WARREN BUFFETT CRAZY?
Given the relentless barrage of bad news about the U.S. banking system and the near-constant calls for the government to nationalize the country's biggest banks, you couldn't be faulted for wondering if Warren Buffett had lost his mind when, in a three-hour appearance on CNBC Tuesday, he called this "a great time to be in banking," talked about the massive "earnings power" of banks like Wells Fargo, and said that the government actually doesn't need to supply most banks with "lots of capital."
(Another explanation for Buffett's relatively upbeat forecast was that, in industry parlance, he was just "talking his book," since he has big stakes in banks like Wells Fargo and U.S. Bancorp.) But the truth is that the recent history of U.S. banking suggests there's a chance, at least, that Buffett was right.
Category: capital asset pricing
Posted by: Admin
As the world capital markets lurch from peak to trough, high levels of volatility become common place and averages become meaningless, any form of pricing involving riskfree rates and proxies for the riskfree rate becomes difficult. More than just high volatility in conditions of uncertainty is at play.
Government responses to credit crisis conditions have involved interventions through capital instruments issued by governments and most of all by the interest rates set for discount windows and overnight rates. The overnight cash rate - a typical and perhaps the most widespread government instrument used to implement monetary policy comes to characterise government aspiration and politically held views rather than supply and demand as those parameters relate to factor markets.
Government responses to credit crisis conditions have involved interventions through capital instruments issued by governments and most of all by the interest rates set for discount windows and overnight rates. The overnight cash rate - a typical and perhaps the most widespread government instrument used to implement monetary policy comes to characterise government aspiration and politically held views rather than supply and demand as those parameters relate to factor markets.
