Unstable risk premiums

Aswath Damodaran works on a new book where he looks at shaking up some of the fundamental assumptions that underlie modern finance.

His first chapter on "What if nothing is risk free?" was posted some months ago and you can still get to it by going to:

Into the Abyss

His second chapter builds on a theme that has been a bit of an obsession for him on risk premiums and how they have become more unstable, unpredictable and linked across markets. The paper titled,

"A New Risky World Order: Unstable Risk Premiums - Implications for Practice",

is now ready to download.

Summary

In the last two sections, we have laid out recommendations on the use of risk premiums that range from the use of current premiums, in the context of asset valuation, to normalized premiums for investment analysis, to a combination, when assessing capital structure. Aswath Damodarans recommendations on risk premiums for investment analysis and capital structure:



	Investments / Portfolio Management

Asset Allocation		Compare current implied risk premiums across different markets (equity, bond, real estate, global) and to historical values (to compute normalized values). Allocate more of your assets to those markets where you get the best trade off in terms of returns for risk taken.

Asset Valuation		Use current implied risk premiums and default spreads to value stocks and bonds.

	Corporate Finance

Investment Analysis		Use normalized equity risk premiums and default spreads to compute the cost of equity / capital, especially for long – term investments. For short term investments, stick with current equity risk premiums and default spreads.

Financing Policy		Use normalized equity risk premiums and default spreads to determine “target” debt ratios for long term. Exploit current equity risk premiums and default spreads to alter debt ratios for short term.

Dividend Policy		Set long term dividend policy to reflect normalized equity risk premiums and default spreads. Use stock buybacks and special dividends to take advantage of deviations of current from normalized values.

In both corporate finance and portfolio management, we need assessments of both current and normalized values for risk premiums in different markets.

Conclusion

Investors demand risk premiums as compensation for investing in risky assets and estimates of these risk premiums are central inputs in both investment and valuation. In portfolio management, assessment of risk premiums in different asset markets can affect asset allocation judgments and individual asset valuations. In corporate finance, risk premiums can affect whether, where and how much firms invest, the mix of debt and equity used to fund investments and how much cash gets returned to stockholders in the form of dividends and stock buybacks.

In practice, analysts have for the most part estimated equity risk premiums by looking at historical data and default spreads based upon interest rates paid on existing debt. Implicitly, they are assuming that risk premiums are stable and revert back to historical averages. In this paper, we presented evidence that risk premiums are unstable, do not quickly revert back to historical averages and are linked across different markets. As an alternative to historical risk premiums, we estimated "forward looking" premiums ins risky markets and used these premiums to allocate wealth across asset classes and to value individual companies. We also argue that using these premiums will lead to better investment, financing and dividend decisions in corporate finance.

Now he is working on his third chapter of the book:

"What if nothing is liquid?",

where he hopes to look at what would happen to valuation and corporate finance practice, if markets essentially shut down.