Discussion Of The Risk Premium

WHAT IS THE RISK PREMIUM?

A. In the CAPM model, the risk premium is calculated as the difference between the expected market return (Rm) and the risk-free rate of return (Rf). The time periods used for Rm and Rf should be consistent. For example, the expected market return (Rm) of 12.33% I used in the CAPM calculation is based on historical return data covering the period December 31, 1991 through March 31, 2005. Therefore, in order to determine the risk premium, I have used the average risk-free rate over that same time period. The average risk-free rate for this period was 3.73%, as shown on Schedule TMR-4.

Therefore, the market risk premium in my CAPM calculation is 8.60%.

As shown on page 2 of Schedule TMR-2, Mr. Meredith's proposed market equity

risk premium is 15.87%.

Q. ABOVE YOU INDICATED THAT THE MARKET AVERAGE RISK PREMIUM IN YOUR CAPM CALCULATION IS 8.6%. HOW DOES YOUR ESTIMATE OF RISK PREMIUM COMPARE TO OTHER ESTIMATES OF THE RISK PREMIUM?

A. As already discussed, the market equity risk premium in my CAPM calculation is 8.60%.

This is a relatively high market equity risk premium compared to other estimates I am aware of. The estimates of the equity risk premium among the prominent studies I am aware of, range from a low of 5.5% to a high of 8.63%. Therefore, the estimate of the market equity risk premium in my CAPM calculation is on the high side of that range.

For example, a 2000 study conducted by Ivo Welch involved a survey of 226 academic financial economists to arrive at a "consensus" estimate of the equity risk premium. That study concluded that the consensus estimate among those 226 economists for the equity risk premium is 7% per year over 10 and 30-year time horizons, and 6% to 7% over 1 and 5-year time horizons.

...