Alternative Methods for Determining the Expected Market Risk Premium: Theory and Evidence
Chu, Chen-Chin
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https://hdl.handle.net/2142/71513
Description
Title
Alternative Methods for Determining the Expected Market Risk Premium: Theory and Evidence
Author(s)
Chu, Chen-Chin
Issue Date
1984
Department of Study
Finance
Discipline
Finance
Degree Granting Institution
University of Illinois at Urbana-Champaign
Degree Name
Ph.D.
Degree Level
Dissertation
Keyword(s)
Economics, Finance
Abstract
Based upon the assumption that there exist uncertain inflation and three types of assets--an inflation hedge portfolio, equity assets, and nominal bonds, the theoretical section of the study derives market equilibrium risk premiums among the three types of assets. Two hypotheses are proposed from the two market equilibrium conditions specified in the model. Empirical tests of the two hypotheses demonstrate a statistically significant risk premium between the expected real return on nominal bonds and the expected real return on the inflation hedge portfolio. The tests provide evidence that investors do consider the effect of uncertain inflation on assets' returns when they allocate their initial wealth to different types of assets. Furthermore, the study demonstrates that the asset pricing model under uncertain inflation can be derived from both the mean-variance utility maximization approach and the Arbitrage Pricing Theory approach.
The test results of the random coefficient model show that the market risk premiums are not constant over time; rather the market risk premiums wander around a negative time trend. Alternative methods for estimating the expected market risk premium are proposed. The results show that the estimation methods which follow Merton's model by multiplying the reward-to-risk ratio by the implied variance in options on stock index futures outperform the naive constant expected market risk premium approach. Moreover, the Box-Jenkins approach which utilizes only historical variance of returns on the market does not perform as well as the option approaches which utilize current market prices quoted for options on stock index futures. The study also finds that there is no apparent difference among three option approaches in estimating the implied standard deviation in options on the New York Stock Exchange stock index futures. Overall, the study shows that the implied standard deviation in options on stock index futures provides information about the volatility of returns on the market and improves the methodology used to estimate the expected market risk premium.
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