Topic_05_E1(1).doc

Topic 5 Exercise 1 Estimating Long-Term Risk Premiums for Securities An online publication that has important information on asset allocation and portfolio concepts is Efficient Frontier. Whenever one investigates valuation of securities and the relationship between risk and return, one is faced with the challenge of estimating the “equity risk premium.” In “The Expected Return One-Step,” William Bernstein presents a compelling argument based on economics for estimating the appropriate long-term equity premium. After reading the short article by Bernstein, answer the following questions: 1. According to Jim Bianco of Bianco Research, what is the primary determinant of long-run bond yields? When will it make sense for corporations to borrow funds? The main determinant of the bond yield is the growth of GDP and not the supply of bonds in the market. Businesses will seek to invest when the growth rate in GDP is high. High rates of growth in GDP present profitable opportunities for firms to invest in real assets to produce returns. When the growth rate in GDP is expected to be high, businesses will increase there demand for bonds, putting upward pressure on interest rates. Mr. Bianco uses the 5-year Treasury as his measure of rates. He argues that it make sense to borrow only when the growth of GDP is larger than the interest rate on the 5-year Treasury. The profitability will increase demand for funds, which will eventually cause the yields to rise. When yields offer higher than expected growth, it will not be profitable for firms to invest using borrowed funds. The firms will not seek borrowed funds in such an environment, eventually causing yields to fall. 2. According to Bernstein, what is the best estimate of the equity risk premium for common stock over the long run? Discuss the rationale presented for his conclusion. Corporate earnings and dividend growth in the long run must also be equal to the GDP growth and therefore the Treasury yield. Since long-term growth for corporate earnings and dividends can’t exceed the Treasury for the long run, the best estimate of the added equity risk premium over the long run would be the dividend yield on stocks. When you put that information together with the long run averages, the total equity risk premium over the long run is about 1.3%. This conclusion is based on empirical observation and economic reasoning. In shorter periods, the market equity premium can be larger or smaller than the dividend yield, but it must be governed by real growth opportunities over the long run.