And how would the price to "reflect the risk" be calculated? Presumably by discounting expected future receipts at the bond yield plus the equity risk premium, so you end up in the same spot.
Just want to make sure we are talking the same language. Let's imagine we have a betting slip which pays €2 if a coin toss comes up Heads and zero otherwise. A fair (efficient?) price for this slip "reflecting the risk" would be €1. However, for investors anyway, they should want compensation i.e. a premium for the risk as well as a reflection of it. They might only give you 80c.
Ahh! Now we are getting to the nub. A major focus of the dismal science is to explain pricing in terms of human preferences. A few of the basics are: people prefer more rather than less, people prefer now rather than later, people prefer certainty rather than risk etc. Of course these are generalisations, monks who have taken a vow of poverty prefer less rather than more, gamblers seek out risk even at the expense of an overall expected loss. But stockmarket prices are assumed to be dominated by investors rather than gamblers or monks. It is consistent with these assumptions that the price of a future uncertain cashflow would be less than its discounted expected value.I like the way you have formulated the question.
But if the market is efficient, why should there be a premium over the discounted value of the expected future receipts.
Our posts crossed. We better heed Colm's warning not to engage in a medieval theological debate. Financial theory does not see the EMH and the ERP as contradictions. The fundamental premise of the EMH is that there are no risk free arbitrage profits to be made and this does not logically rule out an ERP.Excellent comparison.
I will happily offer you 85 cent for that betting slip.
And so on until any premium is eliminated, unless of course the market is inefficient.
Indeed if we live in a world which has come up Trumps so often you would expect a reverse equity risk premium. By which I mean equities would become overvalued because investors would see that they continually out perform.
Or to go back to your illustration. If your coin came up heads 10 times in a row as you suggest for the US markets, and I agree. Then I suspect that betting slips would sell for €1.01 if not more.
No, there shouldn't be a premium. The key issue though is the rate at which future receipts are discounted.But if the market is efficient, why should there be a premium over the discounted value of the expected future receipts.
We use cookies and similar technologies for the following purposes:
Do you accept cookies and these technologies?
We use cookies and similar technologies for the following purposes:
Do you accept cookies and these technologies?