Insights on Equity Risk from CFO Market Expectations

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

2. Graham/Harvey: Expectations of Risk PremiaMeasuring CFO Market Expectations • Survey CFOs every quarter • Q2 2000 through Q2 2002 (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 PremiaAcross Time and Different Horizons • Ten-year risk premium around 3.5% and stable whereas one-year risk premium quite variable 10-year premium 1-year premium

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

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

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

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

8. Graham/Harvey: Expectations of Risk PremiaMeasuring Volatility

9. Graham/Harvey: Expectations of Risk PremiaMeasuring Volatility • 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 PremiaPast Returns Impact Expected Volatility • Average one-year volatility not related to past quarter’s returns

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

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

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

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

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

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

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

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

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

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

21. Graham/Harvey: Expectations of Risk PremiaExpected 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 PremiaExpected Reward and Risk • One-year average volatility weakly negatively related to expected returns

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

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

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

26. Graham/Harvey: Expectations of Risk PremiaImpact of September 11, 2001

27. Graham/Harvey: Expectations of Risk PremiaWhat 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 PremiaOutstanding 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 PremiaInterviews • 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 PremiaAppendix • 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 PremiaAppendix Proportion 1-year individual volatilities September 10, 2001

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