Equity Risk Premium in India
There is a big debate on what is the right equity risk premium for any country and whether the historically realized risk premium is more than enough given the risk associated with investing in equity. Using more than 100 years of data, Dimson, Marsh, and Staunton have found that the risk premium in the US is about 7.6 percent.
Unlike in the US, we do not have a rich array of historical data on the stock returns in India, though Mumbai Stock Exchange in more than 100 years old. Using 26 years of the data (available in the website of RBI), I estimated the risk premium in India. I found that the return on Sensex was on average 13.3 percent more than the yield on 1-year Government Securities (my proxy for a risk-free asset) in India. If we estimate the market risk premium using the post 1991 data, then the equity premium is about 9 percent in India. This comes pretty close to the figure Prof. Rajnish Mehra obtained by using 13 years of data from India. His estimate of the equity risk premium in India is 9.7 percent.
Is this risk premium more than necessary given the risk involved in investing in India? the annualized standard deviation for the 1900-2003 period was 20.1 percent (Dimson, Marsh, and Staunton's study). It was 28.37 percent in India. Ignoring the fact that risk is time-varying, the Sharpe Index in US is 0.378. It is 0.47 for India. For the post-1991 period, the Sharpe Index is much lower at 0.302.
If there is an equity premium puzzle in the US, then there certainly is one in India. The risk premium is just too high given the risk involved.
I am currently working on it. I will post my actual results later.
P.S. There was a mistake in my yesterday's posting. I did not include dividends while estimating returns on Sensex.
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Unlike in the US, we do not have a rich array of historical data on the stock returns in India, though Mumbai Stock Exchange in more than 100 years old. Using 26 years of the data (available in the website of RBI), I estimated the risk premium in India. I found that the return on Sensex was on average 13.3 percent more than the yield on 1-year Government Securities (my proxy for a risk-free asset) in India. If we estimate the market risk premium using the post 1991 data, then the equity premium is about 9 percent in India. This comes pretty close to the figure Prof. Rajnish Mehra obtained by using 13 years of data from India. His estimate of the equity risk premium in India is 9.7 percent.
Is this risk premium more than necessary given the risk involved in investing in India? the annualized standard deviation for the 1900-2003 period was 20.1 percent (Dimson, Marsh, and Staunton's study). It was 28.37 percent in India. Ignoring the fact that risk is time-varying, the Sharpe Index in US is 0.378. It is 0.47 for India. For the post-1991 period, the Sharpe Index is much lower at 0.302.
If there is an equity premium puzzle in the US, then there certainly is one in India. The risk premium is just too high given the risk involved.
I am currently working on it. I will post my actual results later.
P.S. There was a mistake in my yesterday's posting. I did not include dividends while estimating returns on Sensex.
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posted by Pitabas Mohanty at 5:01 AM
9 Comments:
Dear Sir,
With regard to the Equity Risk Premium in India, I have a fundamental doubt. Risk Premium, as measured mathematically, by Rm-Rf, is increasing due to Rm going up and Rf (as measured by 10 year bond) going down..This implies that mathematically the Risk Premium is going up. However, when looked at conceptually, the risk premium, which is nothing but a number to the risk perception of the market is going down due to liquidity, better management practices, corporate governance, greater institutional investors, derivatives, role of SEBI as also the role of technology in real time information dissemination.
So my question is...how does these two interpretations-mathematically and conceptually reconcile. Thanks
You are correct in saying that in the recent past rm has increased and rf has come down and hence the 'realized' rm-rf was high. This is a statement about 'history', about what happened in the 'past'. The point is today when you invest in Sensex, will you 'expect' the same high risk premium? And the answer is no.
You are correct in saying that conceptually the risk premium should come down. That is a statement about the 'future', about what one should 'expect' when one invests today. (In fact the risk premium over the post-1991 period is about 4 percent lower than the post-1980 period.)
And the two are different things. Since the stock market is a very risky place it is possible that during some period, the 'realized' risk premium will be high and during some time it will be low and may be even negative. It is just that we are at a time, when the immediate past premiums are too high. But should we 'expect' such high premium to come in the future?
I think 'no'.
How much equity risk premium do analysts take for equity valuations in India?
I heard that these days it is as low as 2-3%
If yes, does this have anything to do with the global liquidity?
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