3.

The Limiting Case: The Market Portfolio

98

¨ The big assumptions & the follow up: Assuming diversification costs
nothing (in terms of transactions costs), and that all assets can be
traded, the limit of diversification is to hold a portfolio of every
single asset in the economy (in proportion to market value). This
portfolio is called the market portfolio.
¨ The consequence: Individual investors will adjust for risk, by
adjusting their allocations to this market portfolio and a riskless
asset (such as a T-Bill):
Preferred risk level Allocation decision
No risk 100% in T-Bills
Some risk 50% in T-Bills; 50% in Market Portfolio;
A little more risk 25% in T-Bills; 75% in Market Portfolio
Even more risk 100% in Market Portfolio
A risk hog.. Borrow money; Invest in market portfolio

Aswath Damodaran
98
 4. The Risk & Expected Return of an
Individual Asset
99

¨ The essence: The risk of any asset is the risk that it adds to
the market portfolio Statistically, this risk can be measured by
how much an asset moves with the market (called the
covariance)
¨ The measure: Beta is a standardized measure of this
covariance, obtained by dividing the covariance of any asset
with the market by the variance of the market. It is a measure
of the non-diversifiable risk for any asset can be measured by
the covariance of its returns with returns on a market index,
which is defined to be the asset's beta.
¨ The result: The required return on an investment will be a
linear function of its beta:
¤ Expected Return = Riskfree Rate+ Beta * (Expected Return on the
Market Portfolio - Riskfree Rate)

Aswath Damodaran
99
 Limitations of the CAPM
100

1. The model makes unrealistic assumptions

2. The parameters of the model cannot be estimated precisely
¤ The market index used can be wrong.
¤ The firm may have changed during the 'estimation' period'
3. The model does not work well
¤ - If the model is right, there should be:
n A linear relationship between returns and betas
n The only variable that should explain returns is betas
¤ - The reality is that
n The relationship between betas and returns is weak
n Other variables (size, price/book value) seem to explain differences
in returns better.

Aswath Damodaran
100
 Alternatives to the CAPM
101
Step 1: Defining Risk
The risk in an investment can be measured by the variance in actual returns around an
expected return
Riskless Investment Low Risk Investment High Risk Investment

E(R) E(R) E(R)

Step 2: Differentiating between Rewarded and Unrewarded Risk
Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)
Can be diversified away in a diversified portfolio Cannot be diversified away since most assets
1. each investment is a small proportion of portfolio are affected by it.
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will
be rewarded and priced.
Step 3: Measuring Market Risk
The CAPM The APM Multi-Factor Models Proxy Models
If there is If there are no Since market risk affects In an efficient market,
1. no private information arbitrage opportunities most or all investments, differences in returns
2. no transactions cost then the market risk of it must come from across long periods must
the optimal diversified any asset must be macro economic factors. be due to market risk
portfolio includes every captured by betas Market Risk = Risk differences. Looking for
traded asset. Everyone relative to factors that exposures of any variables correlated with
will hold thismarket portfolio affect all investments. asset to macro returns should then give
Market Risk = Risk Market Risk = Risk economic factors. us proxies for this risk.
added by any investment exposures of any Market Risk =
to the market portfolio: asset to market Captured by the
factors Proxy Variable(s)
Beta of asset relative to Betas of asset relative Betas of assets relative Equation relating
Market portfolio (from to unspecified market to specified macro returns to proxy
a regression) factors (from a factor economic factors (from variables (from a
analysis) a regression) regression)

Aswath Damodaran
101
 Why the CAPM persists…
102

¨ The CAPM, notwithstanding its many critics and limitations,

has survived as the default model for risk in equity valuation
and corporate finance. The alternative models that have been
presented as better models (APM, Multifactor model..) have
made inroads in performance evaluation but not in
prospective analysis because:
¤ The alternative models (which are richer) do a much better job than
the CAPM in explaining past return, but their effectiveness drops off
when it comes to estimating expected future returns (because the
models tend to shift and change).
¤ The alternative models are more complicated and require more
information than the CAPM.
¤ For most companies, the expected returns you get with the the
alternative models is not different enough to be worth the extra
trouble of estimating four additional betas.

Aswath Damodaran
102
 Application Test: Who is the marginal investor in
your firm?
103

¨ You can get information on insider and institutional holdings in your firm
from:
¤ http://finance.yahoo.com/
¤ Enter your company’s symbol and choose profile.
¨ Looking at the breakdown of stockholders in your firm, consider whether
the marginal investor is
¤ An institutional investor
¤ An individual investor
¤ An insider
¨ Follow up by evaluating whether the marginal investor is likely to be
diversified.
¤ If yes, you are on safer ground using the risk and return models that assume that
only non-diversifiable risk is rewarded.
¤ If no, you will have to adapt your risk measure to bring in some or all o fthe
company-specific risk that you were ignoring.

Aswath Damodaran
103
 Aswath Damodaran 104

From Risk Models to Hurdle Rates:

Estimation Challenges
“The price of purity is purists…”
Anonymous
 Inputs required to use the CAPM -
105

¨ The capital asset pricing model yields the following

expected return:
¤ Expected Return = Riskfree Rate+ Beta * (Expected Return
on the Market Portfolio - Riskfree Rate)
¨ To use the model, we need three inputs:
a. The current risk-free rate
b. The expected market risk premium, the premium
expected for investing in risky assets, i.e. the market
portfolio, over the riskless asset.
c. The beta of the asset being analyzed.

Aswath Damodaran
105
 The Riskfree Rate and Time Horizon
106

¨ On a riskfree asset, the actual return is equal to the

expected return. Therefore, there is no variance around
the expected return.
¨ For an investment to be riskfree, i.e., to have an actual
return be equal to the expected return, two conditions
have to be met –
¤ There can be no default risk, which generally implies that the
security has to be issued by the government. Note, however,
that not all governments can be viewed as default free.
¤ There can be no uncertainty about reinvestment rates, which
implies that it is a zero-coupon security with the same maturity
as the cash flow being analyzed.

Aswath Damodaran
106
 Riskfree Rate in Practice
107

¨ Definition: The riskfree rate is the rate on a zero coupon

default-free bond matching the time horizon of the cash flow
being analyzed.
¨ Implication: Theoretically, this translates into using different
riskfree rates for each cash flow - the 1 year zero coupon rate
for the cash flow in year 1, the 2-year zero coupon rate for
the cash flow in year 2 ...
¨ A Practical Solution: Practically speaking, if there is
substantial uncertainty about expected cash flows, the
present value effect of using time varying riskfree rates is
small enough that it may not be worth it.
¨ In corporate finance, almost everything we do is long term.
So, using a long-term default free rate as the riskfree rate
makes sense.
Aswath Damodaran
107
The Bottom Line on Riskfree Rates

¨ Currency Matching: The riskfree rate that you use in an analysis should be
in the same currency that your cashflows are estimated in.
¤ In other words, if your cashflows are in U.S. dollars, your riskfree rate
has to be in U.S. dollars as well.
¤ If your cash flows are in Euros, your riskfree rate should be a Euro
riskfree rate.
¨ Just use the government bond rate? The conventional practice of
estimating riskfree rates is to use the government bond rate, with the
government being the one that is in control of issuing that currency. In
November 2013, for instance, the rate on a ten-year US treasury bond
(2.75%) is used as the risk free rate in US dollars.
¨ If the government is default-free, using a long term government rate
(even on a coupon bond) as the risk free rate on all of the cash flows in a
long term analysis will yield a close approximation of the true value. For
short term analysis, it is entirely appropriate to use a short term
government security rate as the riskfree rate.

Aswath Damodaran
108
What is the Euro riskfree rate? An exercise
in November 2013
Rate on 10-year Euro Government Bonds: November 2013

9.00%
8.30%

8.00%

7.00% 6.42%
5.90%
6.00%

5.00%
3.90% 3.95%
4.00%
3.30%

3.00% 2.35%
2.10% 2.15%
1.75%
2.00%

1.00%

0.00%
Germany Austria France Belgium Ireland Italy Spain Portugal Slovenia Greece

Aswath Damodaran
109
When the government is default free: Risk
free rates – in November 2013

Aswath Damodaran
110
What if there is no default-free entity?
Risk free rates in November 2013
¨ Adjust the local currency government borrowing rate for default risk to
get a riskless local currency rate.
¤ In November 2013, the Indian government rupee bond rate was 8.82%. the local
currency rating from Moody’s was Baa3 and the default spread for a Baa3 rated
country bond was 2.25%.
Riskfree rate in Rupees = 8.82% - 2.25% = 6.57%
¤ In November 2013, the Chinese Renmimbi government bond rate was 4.30% and
the local currency rating was Aa3, with a default spread of 0.8%.
Riskfree rate in Chinese Renmimbi = 4.30% - 0.80% = 3.50%
¨ Do the analysis in an alternate currency, where getting the riskfree rate is
easier. With Vale in 2013, we could choose to do the analysis in US dollars
(rather than estimate a riskfree rate in R$). The riskfree rate is then the
US treasury bond rate.
¨ Do your analysis in real terms, in which case the riskfree rate has to be a
real riskfree rate. The inflation-indexed treasury rate is a measure of a real
riskfree rate.

Aswath Damodaran
111
 Three paths to estimating sovereign
default spreads
112

¤ Sovereign dollar or euro denominated bonds: The difference

between the interest rate on a sovereign US $ bond, issued
by the country, and the US treasury bond rate can be used as
the default spread. For example, in November 2013, the 10-
year Brazil US $ bond, denominated in US dollars had a yield
of 4.25% and the US 10-year T.Bond rate traded at 2.75%.
Default spread = 4.25% - 2.75% = 1.50%
¨ CDS spreads: Obtain the default spreads for sovereigns in the
CDS market. The CDS spread for Brazil in November 2013 was
2.50%.
¨ Average spread: If you know the sovereign rating for a
country, you can estimate the default spread based on the
rating. In November 2013, Brazil’s rating was Baa2, yielding a
default spread of 2%.
Aswath Damodaran
112
 113
Ta
iw

0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
Cz ane
ec se
h $
Ho Koru
M ng na
al
ay Kon
si a g $
Br R i n
iti
sh ggi t

Aswath Damodaran
K o P ou
re n d
a
Isr n W
ae
l i on
Sh
Ch Pol e ke
i n ish l
es
e Zlot
Ph Rem y
i ll
ip imb
in i
Ch e P
i le e so
M an
e P
Co xi ca eso
lo n P
m
bi es o
an
Ve P
ne Th e so
zu ai
rated

e l Ba
an h
Ru Bo t
In l
do ssia ivar
n
ne R
So sia ubl
ut n e
A f Rup
ric ia
an h
Tu Ran
rk d
In ish
d L
Pa i an ira
kis Ru
t a pe
Ni ni R e
g e up
ria ee
n
Br Nai
az ra
i lia
n
with default risk in November 2013

$R
Figure 4.2: Risk free rates in Currencies where Governments not Aaa
Risk free rates in currencies: Sovereigns

Risk free rate

Default Spread

113
 Risk free Rates in January 2024
114

Aswath Damodaran
114
 Measurement of the equity risk premium
115

¨ The equity risk premium is the premium that investors

demand for investing in an average risk investment,
relative to the riskfree rate. In short, it is the price of risk
in equity markets, rising with fear.
¨ As a general proposition, this premium should be
¤ Greater than zero
¤ Increase with the risk aversion of the investors in that market
¤ Increase with the riskiness of the “average” risk investment
¨ If so, it also follows that equity risk premiums should
change over time, as economic circumstances change
and investor composition also changes.

Aswath Damodaran
115
What is your risk premium?

¨ Assume that stocks are the only risky assets and that you are
offered two investment options:
¤ a riskless investment (say a Government Security), on which you can
make 3%
¤ a mutual fund of all stocks, on which the returns are uncertain
¨ How much of an expected return would you demand to shift
your money from the riskless asset to the mutual fund?
a. Less than 3%
b. Between 3% - 5%
c. Between 5% - 7%
d. Between 7% -9%
e. Between 9%- 11%
f. More than 11%

Aswath Damodaran
116
 Risk Aversion and Risk Premiums
117

¨ If this were the entire market, the risk premium

would be a weighted average of the risk premiums
demanded by each and every investor.
¨ The weights will be determined by the wealth that
each investor brings to the market. Thus, Warren
Buffett’s risk aversion counts more towards
determining the “equilibrium” premium than yours’
and mine.
¨ As investors become more risk averse, or the market
becomes “more risky”, you would expect the
“equilibrium” premium to increase.
Aswath Damodaran
117
 Risk Premiums do change..
118

¨ Go back to the previous question. Assume now that

you are making the same choice but that you are
making it in the aftermath of a stock market crash (it
has dropped 25% in the last month). Would you
change your answer?
a. I would demand a larger premium
b. I would demand a smaller premium
c. I would demand the same premium
¨ If your equity risk premium rises, what should
happen to stock prices, all else held constant?
Aswath Damodaran
118
 Estimating Risk Premiums in Practice
119

1. Survey Premiums: Survey investors on their desired

risk premiums and use the average premium from
these surveys.
2. Historical Premiums: Assume that the actual
premium delivered over long time periods is equal
to the expected premium - i.e., use historical data.
3. Implied Premiums: Estimate a forward-looking
premium, based upon today’s asset prices.

Aswath Damodaran
119
 1. The Survey Approach
120

¨ Surveying all investors in a marketplace is impractical.

¨ However, you can survey a few individuals and use these results. In
practice, this translates into surveys of the following:

¨ The limitations of this approach are:

¤ There are no constraints on reasonability (the survey could produce negative risk
premiums or risk premiums of 50%)
¤ The survey results are more reflective of the past than the future.
¤ They tend to be short term; even the longest surveys do not go beyond one year.

Aswath Damodaran
120
 2. The Historical Premium Approach
121

¨ This is the default approach used by most to arrive at the

premium to use in the model
¨ In most cases, this approach does the following
¤ Defines a time period for the estimation (1928-Present, last 50 years...)
¤ Calculates average returns on a stock index during the period
¤ Calculates average returns on a riskless security over the period
¤ Calculates the difference between the two averages and uses it as a
premium looking forward.
¨ The limitations of this approach are:
¤ it assumes that the risk aversion of investors has not changed in a
systematic way across time. (The risk aversion may change from year
to year, but it reverts back to historical averages)
¤ it assumes that the riskiness of the “risky” portfolio (stock index) has
not changed in a systematic way across time.

Aswath Damodaran
121
Historical ERP: A Historical Snapshot

Historical
premium for
the US

¨ If you are going to use a historical risk premium, make it

¤ Long term (because of the standard error)
¤ Consistent with your choice of risk free rate
¤ A “compounded” average
¨No matter which estimate you use, recognize that it is
backward looking, is noisy and may reflect selection bias.

122
 3. A Forward-Looking ERP
123

¨ If you know the price paid for an asset and have

estimates of the expected cash flows on the asset, you
can estimate the IRR of these cash flows. If you paid the
price, this is your expected return.
¤ In the bond market, that is exactly what we do when we
compute the yield to maturity on a bond.
¤ If you assume that stocks are correctly priced in the aggregate
and you can estimate the expected cashflows from buying
stocks, you can estimate the expected rate of return on stocks
by finding that discount rate that makes the present value equal
to the price paid.
¨ Subtracting out the riskfree rate should yield an implied
equity risk premium. This implied equity premium is a
forward-looking number and can be updated as often as
you want.

Aswath Damodaran
123
 Implied ERP in November 2013: Watch
what I pay, not what I say..
¨ If you can observe what investors are willing to pay
for stocks, you can back out an expected return from
that price and an implied equity risk premium.
Base year cash flow (last 12 mths)
Dividends (TTM): 33.22 Expected growth in next 5 years
+ Buybacks (TTM): 49.02 Top down analyst estimate of
= Cash to investors (TTM): 82.35 earnings growth for S&P 500 with
Earnings in TTM: stable payout: 5.59%
Beyond year 5
E(Cash to investors) 86.96 91.82 96.95 102.38 108.10 Expected growth rate =
Riskfree rate = 2.55%
S&P 500 on 11/1/13= Expected CF in year 6 =
1756.54 86.96 91.82 96.95 102.38 108.10 110.86 108.1(1.0255)
1756.54 = + + + + +
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r) (r −.0255)(1+ r)5
2 3 4 5

r = Implied Expected Return on Stocks = 8.04%

Minus

Risk free rate = T.Bond rate on 1/1/14=2.55%

Equals
Aswath Damodaran Implied Equity Risk Premium (1/1/14) = 8.04% - 2.55% = 5.49%
124