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Estimating market risk premium using Markov switching : Tunisian Case

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  1. Introduction
  2. Financial market
    1. De...nition
    2. Financial assets
  3. The financial risk
    1. The financial risk feature
    2. Type of financial risk
    3. Risk and volatility
    4. The risk measurement
  4. The risk premium
    1. The market risk premium
    2. Methods proposed for calculating the market risk premium
  5. The market risk premium: The BVMT Case
    1. Data
    2. Models used to estimate market risk premium
  6. Conclusion
  7. Bibliography

The general increase in volatility of the ?nancial markets can be partly explained by the growing uncertainly of the economic environment. It is, on the other hand, a reflection of the growing efficiency and integration of the financial markets allow the almostinstantaneous move of capital from one market place to another and therefore the rapid assimilation of any new, available information. Until the last years, the investors had not seen consecutive negative annual stock market returns since the 1970s. In contrast, during the 1980s and 1990s the market produced its best 20-year performance ever. In fact, Most investors, portfolio managers, corporate financial analysts, investment bankers, commercial bank loan o¢ cers, security analysts and bond-rating agencies are concerned about the uncertainty of the returns on their investment assets, caused by the variability in speculative market prices (market risk) and the instability of business performance (credit risk) Derivative instruments have made hedging of such risks possible. Hedging allows the selling of such risks by the hedgers, or suppliers of risk, to the speculators, or buyers of risk, but only when such risks are systematic, i.e., when they show a certain form on inertia or stability. Indeed, the current derivative markets are regular markets where "stable, » . Unfortunately, all there financial markets su¤er from major deficiencies. The notion that risk matters, and that riskier investments should have a higher expected return than safer investments, to be considered good investments, is intuitive. Thus, the expected return on any investment can be written as the sum of the risk-free rate and an extra return to compensate for the risk. The risk premium is a fundamental and critical component in portfolio management, corporate finance and in valuation. Given its importance, it is surprising that more attention has not been paid in practical terms to estimation issues. The disagreement in both theoretical and practical terms remains on how to measure the risk, and how to convert the risk measure into an expected return that compensates for risk. The estimation of the equity risk premium is in general a di¢ cult task, but in emerging markets the challenge is simply formidable, for at least two reasons. First, usually in emerging markets researches have to cope with the general lack of relevant data, particularly the long series that are needed to study the equity premium. Second, even if the world equity premium were stable, the equity risk premium of an emerging market may change over time, as its degree of integration to world capital markets change. The objective of this work is to provide an estimation of the Tunisian Market Risk Premium following the papers of Damodaran (2002) , Godfrey, S. and R. Espinosa, (1996), Fama, Eugene F., and Kenneth R. French, (2002) and Hamilton, J. (1989). To attempt this objective, our works will be structured as follows. First, we present some generalities about the financial market and the financial assets. Next, we present the financial risk and the methods of measurement. In the third chapter, we will define the market risk premium and present some methods which will be used to estimate this number for the Tunisian market. Finally, we use these models to estimate the Tunisian Market Risk Premium over more than one decade. This last chapter is based upon BVMT index, the money market rate, the inflation rate and dividend data collected from "La Bourse des Valeurs Mobileres de Tunis" and "Banque Centrale de Tunisie".

[...] -The Monthly SP 500 Index and his return -The US Risk Free Rate : we have used the deposit rate for 1 month -The US Market Risk Premium using the historical methods (eq -The Tunisian Market Risk Premium (eq The above chart compares, for each month, The Money Market Rate (red line),The BVMT Index Return (blue line) and the Arithmetic Market Risk Premium Standard Deviation (green line). The table above summaries statistics for market risk premium for the three period Figure 5.4 : STD DEV MMR vs STD DEV INDEX RETURN vs STD DEV MRP Table 5.3 : The Market Risk Premium Estimates using model 3 PRMMA 1992-1998 1999-2005 1992 PRMAA 4,29% - PRMMG 0,34% - PRMAG 4,21% - SIGMA PRMMA Nbr Obs The rst and third columns report the arithmetic and geometric monthly market risk premium average respectively. [...]

[...] While numerical di¤erences in the real and nominal approaches may exist, their magnitudes are expected to be small Methods proposed for calculating the market risk premium While academic textbooks typically give the MRP as the di¤erence between the return on the market and that of a riskless asset, this basic de nition does not provide enough information to apply practically. The rst step in measuring the MRP for practical use is determining exactly what application you have in mind. For example, are you measuring the MRP as a purely historical relationship or do you need a prospective MRP as required for forecasting in mean variance optimization and cost of capital analysis? [...]

[...] Rate in Tunisia 5.4 STD DEV MMR vs STD DEV INDEX RETURN vs STD DEV MRP The Market Risk Premium evolution during the sample 1992- The Earning and Dividend Ratio Evolution during the sample Estimation using 5 Models during 1992- Estimation using 5 Models during 1999- Estimation using 5 Models during 1992- The estimated Monthly Market Risk Premium Using the 5 Models during 1992- Frequency of observation which the state was The predicted Market Risk Premium and BVMT index return using Model List of Tables The The The The The Market Market Market Market Market Risk Risk Risk Risk Risk Premium Premium Premium Premium Premium Estimates Estimates Estimates Estimates Estimates using using using using using model model model model model Acknowledgments I want rst to thank my Professor Abdelwehed Trabelsi and all my colleagues at BESTMOD Laboratory helped me preparing this theses. [...]

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