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About the predictability of risk premium

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  • Sun Tseu
    I 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
    Message 1 of 3 , Nov 9, 2001
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      I 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 does
       
      If 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
    • Bob Bronson
      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
      Message 2 of 3 , Nov 9, 2001
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        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 premium

        I 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 does
         
        If 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

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      • Sun Tseu
        Concerning 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
        Message 3 of 3 , Nov 12, 2001
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          Concerning 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 -----
          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 premium

          I 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 does
           
          If 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

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