You will realise from the calculations that the risk premium had changed slightly from 20X1 to 20×2. If you had used the calculated risk premium for 20×1 as an input into your decision-making for 2ox2, you will be off by about 7.5%. Risk premium for a particular share generally does not stay the same every year and in some equity down years, the premium will be negative.
Most investors use an average of the risk premium for a security or asset class. The average for the equity asset class itself over long periods is somewhere between 4% and 8%. That is the generally accepted range for equity risk premium.
The risk premium for other asset classes would also be different to compensate for the risk inherently prevalent within the asset class. Real estate is assumed to have a risk premium of between 5% to 7%. Commodities surprisingly have a small risk premium of 1.5% to 3% bas some assume that is no economic benefit investing in commodities and it is pure speculation, thus, it does not merit any risk premium. The important thing to bear in mind is that the amount of risk premium for each asset class will provide the basis of any asset allocation and individual investment decision.
2.5.2 Investment decisions
The individual making the investment decisions will have to determine what the possible risk premium is for the individual securities as well as the asset classes that he will invest in. The ABC Berhad example has shown that returns and risk premiums can vary widely from year to year. Even though the investor knows the long-term average for each asset class, there is a need to assess the possible short-term (one accounting period) return for each of the potential investment.
There is an inverse relationship between potential returns and the risk premium afforded by the market currently. If the investor ascertains that the risk premium is to low for an asset, he actually comes to the conclusion that the asset is over-valued on his metric. Conversely, if he finds that the risk premium is too high for an asset (for instance, due to exaggerated fear in the market place), then invariably he would find that the asset is cheap on his metric. The caveat is that although buying cheap assets and avoiding over-valued ones is the prudent course to pursue as an investor in the long-term, in the short-term this does not guarantee good performance as cheap assets can get cheaper and there is no guarantee that the reversal of valuation will take place within the investor’s
time frame.
2.6 Factors Influencing the Required Rate of Return
The required rate of return is primarily dependent of the risk-free rate of return and the risk premium of the asset or the portfolio.
Required rate of return = Risk – free rate + risk premium
We have already discussed the risk-free rate, which is the return earned from investing in a riskless asset. Obviously, to induce the investor to make an investment in risky assets the return of those risky assets must be above that of the riskless asset. How much higher the required rate of return is will be dependent on the risk premium of the risky asset.
2.6.1 Factors influencing the risk premium of an asset
Time
Relates to the investment horizon of a return producing asset. The longer the investment horizon (time) that an asset needs to produce returns, the higher the required risk premium because of the increasing level of uncertainty involved. Assets that require a long time horizon suich as infrastructure development and private equity investments also look up the capital involved for the lengthy duration and thus deprive the owner of the asset the flexibility to invest in other assets in the meantime. For this long-term commitment, the provider of capital would require a higher risk-premium.
Credit consideration
Relates to the risk that the initial investment (principal) in the risky asset may not be returned to the provider of capital in its entirety or at all. A riskless asset has no risk to the principal but a risky asset has some risk. The lower the credit quality of the asset its, the higher the risk of losing some portion of the principal. Thus a lower credit asset would demand a higher risk premium to compensate for the potential loss of principal.
Inflation outlook
Relates to the anticipated rise in general price level that could erode the purchasing power of money. Returns of assets are generally nominal, i.e. the returns do not take into account the effect of inflation. Thus, if inflation is expected to be 5% in the coming year, an asset that would give nominal return of 4% would actually return a negative 1% in real terms. So if inflation is expected to be higher in the investment horizon, the nominal returns of the asset would also need to be higher to compensate for the erosion of purchasing power.
In summary
The rational investor will only invest in risky assets if there is additional return to compensate him for taking that risk. This additional return is labelled the risk premium. The risk premium of different assets varies and is dependent on the level of risks the investment poses to the investor. The higher the risks, the higher the expected return or demanded return of the asset. This risk premium is influenced by the country where the asset is situated, the currency that it is traded in, the business segment that is involved in and whether the asset is easily liquidated without much market impact.
The investor needs to be aware of the different types of risks that his investment asset and portfolio are subjected to. These include market risks, operational risks end inflation risks. The investor should be aware of the risk measures that the fund manager uses to estimate risks including Value at Risk (VaR), Beta, Sharpe Ratio and standard deviation, as there are drawbacks to each and these measures may understate the risks of the portfolio.
Questions/Answers
1. What is the total return for Share A?
Share A:
Price on 1 January 20X1 = RM1.00
Price on 31 December 20X1 = RM1.10
Dividends Paid for 20X1 = Rm0.02
A. +10%
B. -10%
C. +12%
D. +5%
2. Real returns account for the loss of purchasing power in the course of the accounting period and reflect the return to the investor. – TRUE
3.Market risk is also known as ______________
A. Systematic Risk
B. Unsystematic Risk
C. Beta
D. Liquidity Risk