Preface
This paper is written under the assumption that the reader is aware of the basic risk premium evaluation models and theories such as the Modern Portfolio Theory and the Capital Asset Pricing Model. This article explains why there was a need for such evaluation mechanisms and why, in some way shape or form, these models were flawed and hence there was and is a need for a new mechanisms for evaluating risk premiums.
Evolution of models to calculate Risk Premiums
In the realm of corporate finance, investments, and valuations, the central pillar of all estimates is the risk premium associated with an asset class. Over the years, there have been many models that have been used to calculate the risk premium, each with its own assumptions and restrictions. First, let us understand why there is a need for a risk premium or for such models as a whole. When compared to the hypothetical risk free investment, each alternate investment asset has a degree of risk and an amount of return, to compensate for that risk, associated to it. There are two major factors that an investor takes into account before making an investment decision, risk aversion and macro-economic perception.
In order to understand the genesis of the models and the underlying set of issues they solve and simultaneously have, let us consider a novice investor. The investor is looking at the US stock market and, for the sake of simplicity, wants to invest only in stocks. The primary question for the investor is which stock(s) to invest in. A logical first step might include collating a list of, say ten, stocks that have had the highest return for the past year in the, investor’s favorite, airline industry.
Now, investing in just one stock would not be a good idea because if the particular airline company performs poorly (drunk pilots flying the plane), that might affect the stock price and the