1 Expectations of Equity Risk Premia, Volatility, and Asymmetry: From a Corporate Finance Perspective John R. Graham Duke University, Durham, NC USA Campbell R. Harvey Duke University, Durham, NC USA National Bureau of Economic Research, Cambridge, MA USA Western Finance Association Meetings Park City, Utah June 2002

2 Graham/Harvey: Expectations of Risk Premia Measuring CFO Market Expectations Survey CFOs every quarter Q through Q (nine quarters) ~200 responses per quarter (1,900+ 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

3 Graham/Harvey: Expectations of Risk Premia Across Time and Different Horizons Ten-year risk premium around 3.5% and stable whereas one-year risk premium quite variable 10-year premium1-year premium

4 Graham/Harvey: Expectations of Risk Premia Across Respondents at a Point in Time Proportion 10-year premium September 10, 2001

5 Graham/Harvey: Expectations of Risk Premia Across Respondents at a Point in Time Proportion 1-year premium September 10, 2001

6 Graham/Harvey: Expectations of Risk Premia Past Returns and Expected Premia One-year risk premium sensitive to past returns

7 Graham/Harvey: Expectations of Risk Premia Past Returns and Expected Premia 10-year risk premium not sensitive

8 Graham/Harvey: Expectations of Risk Premia Measuring Volatility

9 Able to deduce each respondent’s probability distribution Market volatility is average of individual volatilities (average volatility) + dispersion of risk premium forecasts (disagreement) We consider both components

10 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility Average one-year volatility not related to past quarter’s returns

11 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility Average one-year volatility not related to past month’s returns

12 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility One-year disagreement volatility not linearly related to past quarter’s returns

13 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility Maybe non-linear – but too little data

14 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility One-year disagreement volatility negatively related to past month’s returns

15 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility Ten-year disagreement weakly negatively related to past returns

16 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility Ten-year disagreement negatively related to past month’s returns

17 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Skewness One-year average skewness weakly positively related to past quarter’s returns

18 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Skewness One-year average skewness weakly positively related to past month’s returns

19 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Skewness One-year disagreement skewness positively related to past quarter’s returns

20 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Skewness One-year disagreement skewness positively related to past month’s returns

21 Graham/Harvey: Expectations of Risk Premia Expected Reward and Risk Literature split –Some find negative relation between risk and expected returns which is consistent with asset pricing models –Some find a positive relation

22 Graham/Harvey: Expectations of Risk Premia Expected Reward and Risk One-year average volatility weakly negatively related to expected returns

23 Graham/Harvey: Expectations of Risk Premia Expected Reward and Risk One-year disagreement volatility negatively related to expected returns

24 Graham/Harvey: Expectations of Risk Premia Expected Reward and Risk One-year disagreement volatility negatively related to median expected returns

25 Graham/Harvey: Expectations of Risk Premia Expected Reward and Risk Ten-year disagreement volatility positively related to expected returns

26 Graham/Harvey: Expectations of Risk Premia Impact of September 11, 2001

27 Graham/Harvey: Expectations of Risk Premia What have we learned? Forecasts impacted by past returns (expectational momentum) Some support for the leverage effect with new expectational data Individual volatilities seem low Positive relation between risk and expected return - only at longer horizons

28 Graham/Harvey: Expectations of Risk Premia Outstanding issues One-year forecasts unlikely used as the “hurdle rate” for one-year project evaluation Difference between what CFOs think will happen to the market and their internal hurdle rates

29 Graham/Harvey: Expectations of Risk Premia Interviews Results of four randomly selected CFO interviews: –All used the CAPM for cost of capital –None viewed the one-year premium as the input in the cost of equity calculation – even if the project had a short life

30 Graham/Harvey: Expectations of Risk Premia 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

31 Graham/Harvey: Expectations of Risk Premia Appendix Proportion 1-year individual volatilities September 10, 2001

32 Graham/Harvey: Expectations of Risk Premia Appendix Proportion 1-year individual skewness September 10, 2001