- View SourceI was just doing some crude number crunching trying to figure out what the difference between the Baa and Aaa bond yields could be worth for predicting the return of the S&P 500. I found only meaningless relations. Yes, big surprise.I then tried to understand what could be the rationale behind a potential (and so far non-existent) relation (Yes, this should have been done in the first place). And then it appeared to me that there actually *should* be a relation. Why ?The credit risk premium can widen for 2 reasons :-the probability of future default increase-the probability of future default does not increase but the risk aversion doesIf the probability of default increases, the riskiness of stocks (not just loans) should increase too. So the stock risk premium should increase too.If the risk aversion increases, then, again, the stock risk premium should increase too.In the first case, notice that the risk-adjusted return could stay just the same.Now, did I miss something ?David B
- View Source
**The logic is right, David, but you may have to quantify****more****to isolate the****contribution of default risk to equity****valuation. Exactly what and how did you measure it?****There****are****many****ways to explore yield differences:****averaging, over****different lead and lag time periods****,****the****arithmetic versus****geometric****spreads (e.g. which is****more****relevant: 1% => 2%****as 100 bps or 100% increase?)****of various****term****Treasuries and safer****corporates.****Furthermore, since****default risk has secondary valuation****importance to earnings, its****additive predictive value may****only become apparent****in residuals after****other predictive****factors are removed,****such as: cumulative retained earnings****(which primarily constitute stock holder's equity or net worth****and reflected in book value and Tobin's Q ratio, for example)****and their first derivative (various forms of cash flow used****in computing P/E ratios)****and their second derivative, or****earnings****growth****rates (as reflected in P/E/G ratios).****We are exploring these and other factors in our P/E****Predictor****Study II. Our baseline study, P/E Predictor I,****is available****by****private e-mail****request.****Bob Bronson****Bronson Capital Markets Research**-----Original Message-----**From:**Sun Tseu [mailto:SunTseu@...]**Sent:**Friday, November 09, 2001 6:43 PM**To:**Behavioral-Finance@yahoogroups.com**Subject:**[Behavioral-Finance] About the predictability of risk premiumI was just doing some crude number crunching trying to figure out what the difference between the Baa and Aaa bond yields could be worth for predicting the return of the S&P 500. I found only meaningless relations. Yes, big surprise.I then tried to understand what could be the rationale behind a potential (and so far non-existent) relation (Yes, this should have been done in the first place). And then it appeared to me that there actually *should* be a relation. Why ?The credit risk premium can widen for 2 reasons :-the probability of future default increase-the probability of future default does not increase but the risk aversion doesIf the probability of default increases, the riskiness of stocks (not just loans) should increase too. So the stock risk premium should increase too.If the risk aversion increases, then, again, the stock risk premium should increase too.In the first case, notice that the risk-adjusted return could stay just the same.Now, did I miss something ?David B`you may unsubscribe by sending an email to`

Behavioral-Finance-unsubscribe@yahoogroups.com`Your use of Yahoo! Groups is subject to the Yahoo! Terms of Service.` - View SourceConcerning the measurement of the default risk premium, I simply took the arithmetic difference of Moody's Baa minus Aaa bond yields on a monthly basis, and I just looked at correlations and the likes.It is admittedly a crude investigation. Alternative ways of measurement or time windows could probably do a better job, but I feel this simple experiment should give some results at least to a certain degree if my reasoning was to have any value, even in the presence of other factors.Besides, I am suspicious of data mining.However, it was on the reasoning I especially wanted feedback, so thanks for yours.David B----- Original Message -----
**From:**Bob Bronson**Sent:**Saturday, November 10, 2001 5:04 AM**Subject:**RE: [Behavioral-Finance] About the predictability of risk premium**The logic is right, David, but you may have to quantify****more****to isolate the****contribution of default risk to equity****valuation. Exactly what and how did you measure it?****There****are****many****ways to explore yield differences:****averaging, over****different lead and lag time periods****,****the****arithmetic versus****geometric****spreads (e.g. which is****more****relevant: 1% => 2%****as 100 bps or 100% increase?)****of various****term****Treasuries and safer****corporates.****Furthermore, since****default risk has secondary valuation****importance to earnings, its****additive predictive value may****only become apparent****in residuals after****other predictive****factors are removed,****such as: cumulative retained earnings****(which primarily constitute stock holder's equity or net worth****and reflected in book value and Tobin's Q ratio, for example)****and their first derivative (various forms of cash flow used****in computing P/E ratios)****and their second derivative, or****earnings****growth****rates (as reflected in P/E/G ratios).****We are exploring these and other factors in our P/E****Predictor****Study II. Our baseline study, P/E Predictor I,****is available****by****private e-mail****request.****Bob Bronson****Bronson Capital Markets Research**-----Original Message-----**From:**Sun Tseu [mailto:SunTseu@...]**Sent:**Friday, November 09, 2001 6:43 PM**To:**Behavioral-Finance@yahoogroups.com**Subject:**[Behavioral-Finance] About the predictability of risk premiumI was just doing some crude number crunching trying to figure out what the difference between the Baa and Aaa bond yields could be worth for predicting the return of the S&P 500. I found only meaningless relations. Yes, big surprise.I then tried to understand what could be the rationale behind a potential (and so far non-existent) relation (Yes, this should have been done in the first place). And then it appeared to me that there actually *should* be a relation. Why ?The credit risk premium can widen for 2 reasons :-the probability of future default increase-the probability of future default does not increase but the risk aversion doesIf the probability of default increases, the riskiness of stocks (not just loans) should increase too. So the stock risk premium should increase too.If the risk aversion increases, then, again, the stock risk premium should increase too.In the first case, notice that the risk-adjusted return could stay just the same.Now, did I miss something ?David B`you may unsubscribe by sending an email to`

Behavioral-Finance-unsubscribe@yahoogroups.com`Your use of Yahoo! Groups is subject to the Yahoo! Terms of Service.``you may unsubscribe by sending an email to`

Behavioral-Finance-unsubscribe@yahoogroups.com`Your use of Yahoo! Groups is subject to the Yahoo! Terms of Service.`