1. Copyright 2001. John R. Graham and Campbell R. Harvey. 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 http://www.duke.edu/~charvey AIMR Equity Risk Premium Forum New York, NY November 8, 2001

2. Copyright 2001. John R. Graham and Campbell R. Harvey. 2 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

3. Copyright 2001. John R. Graham and Campbell R. Harvey. 3 Graham/Harvey: Expectations of Risk Premia Across Time and Different Horizons 10-year risk premium around 4% and stable whereas 1-year risk premium quite variable 10-year premium1-year premium

4. Copyright 2001. John R. Graham and Campbell R. Harvey. 4 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Premia 1-year risk premium sensitive to past returns

5. Copyright 2001. John R. Graham and Campbell R. Harvey. 5 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Premia 10-year risk premium not sensitive

6. Copyright 2001. John R. Graham and Campbell R. Harvey. 6 Graham/Harvey: Expectations of Risk Premia 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 ______%”

7. Copyright 2001. John R. Graham and Campbell R. Harvey. 7 Graham/Harvey: Expectations of Risk Premia Measuring Volatility Market volatility is average of individual volatilities (average volatility) + dispersion of risk premium forecasts (disagreement) We consider both components

8. Copyright 2001. John R. Graham and Campbell R. Harvey. 8 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility Average volatility (1-year) weakly related to past returns

9. Copyright 2001. John R. Graham and Campbell R. Harvey. 9 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Volatility Disagreement (1-year) strongly related to past returns

10. Copyright 2001. John R. Graham and Campbell R. Harvey. 10 Graham/Harvey: Expectations of Risk Premia Past Returns Impact Expected Skewness Average skewness (1-year) strongly related to past returns

11. Copyright 2001. John R. Graham and Campbell R. Harvey. 11 Graham/Harvey: Expectations of Risk Premia Expected Premia and Expected Volatility Average volatility (1-year) negatively related to expected returns

12. Copyright 2001. John R. Graham and Campbell R. Harvey. 12 Graham/Harvey: Expectations of Risk Premia Expected Premia and Expected Volatility Disagreement volatility (1-year) strongly negatively related to expected returns

13. Copyright 2001. John R. Graham and Campbell R. Harvey. 13 Graham/Harvey: Expectations of Risk Premia Expected Premia and Expected Volatility Disagreement volatility (10-year) strongly positively related to expected returns

14. Copyright 2001. John R. Graham and Campbell R. Harvey. 14 Graham/Harvey: Expectations of Risk Premia Impact of September 11, 2001

15. Copyright 2001. John R. Graham and Campbell R. Harvey. 15 Graham/Harvey: Expectations of Risk Premia 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

16. Copyright 2001. John R. Graham and Campbell R. Harvey. 16 Graham/Harvey: Expectations of Risk Premia 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

17. Copyright 2001. John R. Graham and Campbell R. Harvey. 17 Graham/Harvey: Expectations of Risk Premia 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

18. Copyright 2001. John R. Graham and Campbell R. Harvey. 18 Graham/Harvey: Expectations of Risk Premia 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

19. Copyright 2001. John R. Graham and Campbell R. Harvey. 19 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

20. Copyright 2001. John R. Graham and Campbell R. Harvey. 20 Graham/Harvey: Expectations of Risk Premia Appendix Proportion 1-year premium September 10, 2001

21. Copyright 2001. John R. Graham and Campbell R. Harvey. 21 Graham/Harvey: Expectations of Risk Premia Appendix Proportion 10-year premium September 10, 2001

22. Copyright 2001. John R. Graham and Campbell R. Harvey. 22 Graham/Harvey: Expectations of Risk Premia Appendix Proportion 1-year individual volatilities September 10, 2001

23. Copyright 2001. John R. Graham and Campbell R. Harvey. 23 Graham/Harvey: Expectations of Risk Premia Appendix Proportion 1-year individual skewness September 10, 2001