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Return and Risk premium models – how do navigate it all?

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    • Avatar of Prosper0Prosper0
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        • CFA Level 2
        27 Apr 2018 at 3:55 am
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        I think the title speaks for itself, there is just so much of it!

        Things that are confusing me – what risk free rate to use. I got burnt by 2 questions in one item set from Kaplan (I think it was Portfolio management rather than Equity but no matter) where they asked to calculate risk premium – one from APT model and the other one from macroeconomic factor. There were 2 risk free rates given (TBills and Tbonds or some such, basically a short-term and long-term rf rates) and for some reason each question used a different risk free rate. Why? I don’t get it? Are some of the models explicitly more short term than others?

        Also, one on CAPM. Now thanks to my background, I am pretty on CAPM and econometrics in general. What I dont get is how to distinguish between the following 2 applications:

        1) Ri=alpha + beta*RM
        2) Ri=rf + beta*MRP, where MRP = RM-rf

        Any ideas?

        Also, what are managing to learn all the different models and their applications?

      • Avatar of Prosper0Prosper0
        Participant
          • CFA Level 2
          27 Apr 2018 at 7:21 am
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          Nobody to chip in with their views?

        • Avatar of Stuj79Stuj79
          Participant
            • CFA Charterholder
            27 Apr 2018 at 7:56 am
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            As far as I am aware:

            CAPM = Long-term Govt Yield

            BYPRP = Long-term firm yield

            Fama French = Short-term Yield

            Pastor Stanbaugh= Short-term yield

            Ibbotson Chen = Supply Side = Not specified in the CFAI curriculum

            BIRR = Short-term yield

            GGM = Long-term yield

            To answer your second question I THINK it is as follows:

            1) This is the output of a linear regression model using historic data to quantify the stock’s relationship to market returns – with “alpha” being the stock specific return expected when the market return is zero, and “beta” being the slope coefficient between the market returns and stock returns

            2) This is a forward looking “ex ante” model of expected returns based on the specific CAPM theory. It doesn’t include an “alpha” as there is no historical regression.

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