Does history repeat itself? In general, as we add older data, we gain precision It the expense of introducing potential bias. Striking the right balance is difficult and requires sound judgment Despite its drawbacks, the long-run average return is a popular estimator for expected returns on aggregate market indices. Unfortunately, we have no theory for what the expected market return should be Luckily for individual stocks and most portfolios, we can rely on estimates produced by theoretical asset pricing models. Those estimates tend to be substantially more precise than sample averages
Does history repeat itself? ◼ In general, as we add older data, we gain precision at the expense of introducing potential bias. Striking the right balance is difficult and requires sound judgment. ◼ Despite its drawbacks, the long-run average return is a popular estimator for expected returns on aggregate market indices. Unfortunately, we have no theory for what the expected market return should be. ◼ Luckily, for individual stocks and most portfolios, we can rely on estimates produced by theoretical asset pricing models. Those estimates tend to be substantially more precise than sample averages
Theory is good CAPM In order to use capm Riskless rate beta equity premium
Theory is good ◼ CAPM ◼ In order to use CAPM ◼ Riskless rate, ◼ beta, ◼ equity premium
Theory is good What value we choose for the risk-free rate depend on our objectives If we want to forecast expected stock returns over the next month, the appropriate risk-free rate is the yield to maturity on a treasury bill that matures in one month If we want to estimate the firms cost of capital in order to value the firm's future cash flows the risk-free rate should be derived from a longer- term treasury bond such as a ten year bond. The bond' s duration should come close to the duration of the firm' s cash flows Very long-term bonds should be avoided because their yields might also reflect premiums for risks such as inflation
Theory is good ◼ What value we choose for the risk-free rate depend on our objectives. ◼ If we want to forecast expected stock returns over the next month, the appropriate risk-free rate is the yield to maturity on a Treasury bill that matures in one month. ◼ If we want to estimate the firm's cost of capital in order to value the firm's future cash flows, the risk-free rate should be derived from a longer-term Treasury bond, such as a tenyear bond. The bond's duration should come close to the duration of the firm's cash flows. ◼ Very long-term bonds should be avoided, because their yields might also reflect premiums for risks such as inflation