Market Risk Premium - Definition, Formula and Explanation
The higher the standard deviation, the less certain the rate of return in any one given Capital market history shows us that the average return relationship from . Answer to Need an answer ASAP Capital market history shows us that the average return relationship from lowest to highest be. Some investments, such as those sold on the exempt market are highly speculative and very risky. This Interactive investing chart shows that the average annual return on treasury bills since was Consequently, the historical equity premium was approximately 5% per annum. Connect With Us.
The demand for savings, in turn, is determined by company decisions about how much capital to use in the production process, by government borrowing needs, and by household demand for credit. An aging population can affect both the supply of and the demand for savings, and there are potentially countervailing effects.
This makes it difficult to provide a clear-cut answer to the question, Are asset returns more likely to rise or to fall as a consequence of population aging?
The committee concludes that the net effects of population aging on rates of return are likely to be modest. This analysis is generally set in a framework in which global asset markets operate as an integrated whole, which means that assets can migrate freely to wherever they are expected to earn the highest rate of return.
Migration of assets tends to equalize expected returns internationally: The global supply and demand for assets determines expected returns. This is why the aging of the global population, weighted by the amount of assets that residents of various nations hold, rather than the aging of the U.
While the committee focuses on the mobile assets case, if asset mobility is limited, then while global population dynamics may affect rates of return, domestic demographic factors may also matter.
Table shows the evolution of the U. The committee reports GDP-weighted values because it does not have detailed information on the aggregate asset holdings in each nation.
The table shows that the global population today is older on a GDP-weighted basis than on an equal-weighted basis. It also shows that GDP weighting tends to reduce the disparity between the aging of the U. The per capita GDP-weighted old age dependency ratio for the global economy rises more slowly than that for the United States for the next 20 years, but it catches up in the subsequent two decades.
Each year households decide how much to consume. When consumption exceeds their income, they must draw down savings to finance consumption, and vice versa.
Companies decide whether to retain or distribute their earnings and how much to invest; and governments decide whether or not to save by collecting taxes in excess of current spending. Companies that seek resources to deploy plant or equipment in their business or to invest in new technology, households that wish to borrow because their desired consumption exceeds their current income, and governments that issue bonds because their tax revenues fall below their outlays determine the demand for savings.
Household Savings The standard theory of consumer behavior has clear implications for the amount of savings that households will choose to hold. The theory posits that, all else equal, households prefer more consumption to less, smoother consumption to a more volatile consumption profile, consuming sooner to consuming later, and greater certainty about their consumption path.
For a given level of expected returns, the desire to smooth consumption over time causes households to hold higher levels of savings when they expect consumption growth to be relatively slow; conversely they save less or try to borrow against future income when expected consumption growth is more rapid.
Impatient households postpone the accumulation of savings until they near retirement age. Risk aversion motivates higher levels of savings as a buffer against adverse economic shocks.
While the effect of higher expected rates of return on the household saving rate is theoretically ambiguous, under many reasonable modeling assumptions it seems that higher returns draw forth higher saving. An aging population can affect aggregate savings in a variety of ways. Because older households on average hold more savings than younger households, an aging population will tend to display rising savings per capita. The desire to smooth consumption leads households to save while working so that they can draw down their assets to finance their retirement years.
Higher aggregate savings per worker can affect the marginal product of capital—the amount of additional output that is produced from an incremental deployment of capital investment—if it translates into a higher level of capital per worker. Economic models of production imply that when the number of workers per unit of productive capital declines, the marginal product of capital will decline. A lower marginal product of capital would translate into a lower rate of return on incremental investments, which could reduce the incentive to save and partly offset the aging-related increase in savings per capita.
Population aging may also affect household savings by affecting the expected path of productivity growth and thereby consumption growth. Productivity growth is the most important determinant of consumption growth over long horizons. The rates of output and consumption growth over substantial periods of time are roughly proportional to the growth rate of output per unit of labor used in production. Chapter 6 reviews the evidence of the effects of an aging population on productivity and concludes that there is likely to be a negligible effect of the age composition of the labor force on the level of aggregate productivity over the next two decades.
Another way by which population aging may affect savings is its effect on economic uncertainty. For example, households may increase their savings if the imbalances between promised social insurance benefits and the tax revenues available to pay them create doubts about whether benefits will be fully paid or whether taxes will be sharply raised. Aggregate savings could fall, however, if developing countries introduce more extensive social insurance programs for their older citizens that reduce their incentives for private saving.
China is currently pursuing policies of this type. Savings by Companies and Governments Companies and governments also make decisions that affect the aggregate supply of savings. Companies save when they retain earnings instead of paying them out to shareholders. Retained earnings generally are invested in a firm's own operations or in securities issued by other entities. Companies have a greater incentive to save when expected returns are higher and when there is more uncertainty about the availability of bank or investor financing.
Because companies operate on behalf of the households that own them, household preferences are generally taken to be the fundamental determinants of company saving and investment decisions. The foregoing discussion of the effect of population aging on household savings therefore is suggestive of the forces that will indirectly affect corporate savings as well.
Governments save when current-year tax revenues exceed current-year spending, i. Often those surpluses are used to pay down government debt, but they also can be invested in real or financial assets. It is likely that increases in government saving are partially but not fully offset by reductions in household saving, so that government saving increases the overall supply of saving.
The effect of government saving programs on household saving may depend on the nature of the tax and spending changes that are adopted.
Except for a few years in the late s, the U. Federal budget deficits have been particularly large as a result of the deep recession that began in Projections described elsewhere in this report suggest growing future deficits resulting from increased demands on social insurance programs. Population Aging and the Demand for Savings Companies use savings when they deploy various types of capital, such as land, real estate, equipment, and research and development capital, as inputs to production.
They invest more when there are a greater number of profitable investment opportunities. When the return demanded by savers is low, a firm's discount rate will also be low, and the number of projects that will generate returns in excess of this threshold, or that will meet a present discounted value test, will be high. Population aging may affect a company's demand for savings in several ways.
First, as per capita labor supply declines and labor becomes relatively scarce, firms may wish to substitute capital for labor; this would stimulate investment demand. More capital-intensive production processes may also allow older workers to extend their stay in the labor force. A mitigating effect is that raising the capital: Households demand savings when they borrow to finance purchases of homes or cars, to invest in education, or to finance consumption. The aging of the population may affect household borrowing demand.
Older households on average borrow less than younger ones—they are less likely to want to buy a bigger house or to attend college, and they have less future earning capacity to borrow against. However, if financial product innovations create new ways for older households to use their home equity to finance consumption, it is possible that borrowing by older households in the future may be higher than it is today.
The risk-return relationship
Governments borrow not only to pay for current spending, but also to invest in capital that is used in the production of government services such as transportation, education, and health care. An aging population per se is unlikely to have a significant impact on that aspect of savings demand. A more important way in which aging may affect government demand for savings is by its impact on social insurance programs and associated budget deficits, as noted above.
Asset Market Equilibrium and Expected Returns Expected rates of return shift over time so as to equalize the supply of and demand for savings.
The foregoing discussion underscores the many factors that influence supply and demand and their interactions with an aging population. The underlying determination of returns, however, is straightforward. An increase in expected returns increases the reward to saving. Whether this raises or lowers the supply of saving is theoretically indeterminate and has proven difficult to measure empirically.
At the same time, higher expected returns reduce the demand for savings, because it becomes more difficult to find investment opportunities that earn a sufficient return. To summarize this discussion, Table indicates the main channels through which an aging population can affect expected returns. Because the various effects point in different directions, evaluating the net effect of population aging on expected returns requires using an economic model that makes it possible to compare the quantitative effects of different influences.
RISK AND RETURN The preceding discussion implicitly assumed a single rate of the return to investors, but in practice, there are a variety of real and financial assets with different risk attributes and correspondingly different expected returns. For example, households can save by holding stocks or bonds, or by accumulating equity in their homes. Earlier chapters of this volume examine how the choice between such alternatives may be affected by population aging.
From a macroeconomic perspective, a key question is to what extent an aging population will affect the aggregate risk appetite of the capital market. If older investors are more risk-averse than younger ones, then as the population ages, the price of risky assets may decline, and the required risk premium might rise, relative to historical experience. Several studies notably Bodie, Merton, and Samuelson, ; Jagannathan and Kocherlakota, have suggested that older households may be less tolerant of investment risk because they cannot offset adverse shocks to the value of their asset holdings by increasing their labor supply.
The typical advice of financial advisers to reduce exposure to investment risk with age is consistent with that reasoning. Several recent analyses suggest that the link between age and the tolerance for investment risk—and its relation to labor income—may be more complicated.
What is CAPM - Capital Asset Pricing Model - Formula, Example
For example, Benzoni, Collin-Dufresne, and Goldstein argue that labor income is a significant source of long-run market risk for young people, and hence they would be expected to be more averse to investment risk than middle-aged households whose lifetime labor income is more certain.
They predict a hump-shaped pattern of risky asset holding over the life cycle, which in aggregate would imply greater risk tolerance when a larger portion of the population is middle-aged. Changing tastes for housing and financial assets over the life cycle may also affect both the level of required returns and the risk premium for risky as opposed to safe financial assets.
For example, Bakshi and Chen suggest that the demand for financial assets may increase as people age and their demand for housing diminishes; this could, in turn, affect financial market returns. Empirical and Simulation Evidence on Demographic Structure and Rates of Return To address the quantitative effect of population aging on rates of return, a number of studies have compared historical returns on financial assets in different time periods or different countries that were characterized by different population age structures.
Other studies have used simulation models that incorporate the supply and demand elements that were described above to analyze the size of these effects. Each of these research strategies has strengths as well as weaknesses. Empirical analyses rest on relatively little historical experience with the type of population aging that many developed nations are about to undergo. Simulation modeling depends on many assumptions about difficult-to-measure parameters such as discount rates, the elasticities of substitution between consumption today and in the future, and the extent of openness in cross-country resource flows.
The committee noted in Chapter 2 that if age-specific asset holdings were not affected by population aging, the change in population age structure between and would result in a noticeable increase in per capita asset holdings in the United States.
Table shows mean net worth for households, classified by age of the household head, from the Survey of Consumer Finances. Because of the skewness of the wealth distribution, age-specific means are typically much greater than medians. For analyzing the total supply of savings, however, it is appropriate to focus on means.
This increase of 9. If we just consider the population in the prime working ages 20—64, the ratio of net worth to population aged 20—64 will increase more rapidly 21 percent during this period because the population aged 20—64 will grow more slowly than the total population in the coming decades. Making projections of future asset holdings based on current age-related profiles is challenging, because it is impossible to fully disentangle age and cohort effects on wealth accumulation. For example, it is difficult to determine whether a decline in assets between ages 60—64 and 65—69 reflects a movement along an age-wealth profile, or the fact that those who were in the latter age group experienced different labor market and financial market conditions and were consequently less wealthy than their slightly younger counterparts.
It is also important to recognize that the wealth distribution is highly skewed, so that average asset levels can be quite sensitive to the holdings of a small group of households. There are also important age-related patterns in labor supply. The Bureau of Labor Statistics reports that the fraction of the population aged 18—19 that was employed in was The fraction rose to For those between the ages of 25 and 54, the average was After age 55, however, labor market activity begins to decline, with an employment: The rise in the employment: Age-related changes in the aggregate labor force could affect the rate of return on assets.
Empirical Analyses of Past Returns and Demographic Structure Data on population age structure and rates of return, both over time in individual countries and across nations, can be used to examine the correlation between demographic factors and asset market returns.
While several studies identify a strong relationship between a particular measure of demographic structure and a particular set of asset market returns, others find little or no association.
The research has used a number of different measures of age structure, and some demographic measures do not seem to be related to return outcomes while others do. Arnott and Chavesone of the latest studies in this tradition, examine the empirical relationship between population age structure and stock and bond returns in a number of developed countries. They allow for a relatively flexible relationship between age structure and returns and conclude that rapidly aging countries will experience substantially lower equity returns than other countries.
Capital Asset Pricing Model (CAPM)
The United States, however, is roughly in the middle of the country group that they study, with only modest return effects. Their analysis presumes that each country's demography is related to its asset returns, in contrast to the committee's focus on global aging as the key determinant of rates of return. Brooksin contrast, studies a number of nations and finds no robust relationship between age structure and asset returns.
In fact, in countries with extensive stock market participation, such as Australia, Canada, New Zealand, the United Kingdom, and the United States, he finds that many households continue to accumulate assets well into old age.
Poterba finds that measures of demographic structure have only a weak correlation with asset returns in the United States, with the strongest relationship observed between the price: Geanakoplos, Magill, and Quinzii report that variation in the ratio of middle-aged to young households has predictive power for equity returns in the United States and several other nations.
They also develop a simulation model that suggests a substantial decline in the price: The large variation of findings in the empirical literature is probably due to the relatively slow evolution of demographic variables in the recent past, which means that even when data are available for many years, there may be relatively little effective variation in the explanatory variables.
Simulation Evidence The simulation literature on the effects of changing demographic structure has included studies of a single economy, best interpreted as representing the global economy with fully integrated capital markets, as well as studies that recognize the different current and prospective demographic structures of various regions of the global economy.
Most studies consider a single asset category, which can be thought of as all capital invested in productive uses. The return on such an aggregate capital measure would correspond to a weighted average of the returns that investors earn on stocks and bonds issued by corporations and on their investments in owner-occupied housing and other real estate. The simulation studies suggest that there may be a modest decline in rates of return—between 30 and basis points 1 —in response to population aging of the type that will take place in the United States and other developed nations in the next few decades.
A number of simulation studies have also considered how population aging may affect the equity premium—the difference between the expected return on risky assets such as corporate stocks and safe assets such as Treasury bills.
Brooks suggests that when baby boomers retire, there will be an increase in the equity premium. This would translate into a decline in the value of corporate stocks and generate low returns for investors in this cohort. This result is driven by a large sell-off of equities by retiring baby boomers who want to hold less risky portfolios during retirement.
Boersch-Supan, Ludwig, and Sommer reach the same conclusion. As with the effect of demographic change on overall returns, there is some disagreement about the potential effect of aging populations on the risk premium. Geanakoplos, Magill, and Quinzii and Brooks both predict a fall in the equity premium. Kuhle shows that whether the return on risky relative to less risky assets rises or falls depends on the relative price elasticities of the two asset classes. Existing empirical work does not provide definitive evidence on this elasticity.
In such an integrated global financial market, when the aging population in one nation leads to a rising supply of savings and in the associated physical capital: The open economy setting implies that rate-of-return effects may be small, but it also implies that there may be substantial cross-border financial flows in response to changing demographic structure.
These flows may be of independent interest as a macroeconomic phenomenon. This section describes the patterns of U. In addition, it highlights the potential importance of restrictions on financial flows when different countries are aging at different rates.
The evidence on how global population aging will affect financial flows is based on analysis of historical experience and calculations using simulation models. Bryant's analysis suggests that between the s and the mids, demographic forces were a major factor behind flows of financial capital and direct investment from the Northern to the Southern Hemisphere. However, beginning in the s, he finds that demographic change dampened, rather than augmented, these flows.
His analysis suggests that the pattern of recent decades may persist for some time to come. While the evidence on financial flows from simulation models is somewhat varied, several findings warrant attention. First, the paths of factor prices—the rate of return to capital and the wage rate—as well as aggregate variables such as assets, consumption, and investment, are considerably different under different assumptions about interregional financial flows.
Stocks have a potentially higher return than bonds over the long termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest. BondBond A kind of loan you make to the government or a company.
They use the money to run their operations. In turn, you get back a set amount of interest once or twice a year. If you hold bonds until the maturity date, you will get all your money back as well.
As a shareholderShareholder A person or organization that owns shares in a corporation. May also be called a investor. But if the company is successful, you could see higher dividends and a rising shareShare A piece of ownership in a company.
Inverse relationship between capital price and returns (video) | Khan Academy
But it does let you get a share of profits if the company pays dividends. Some investments, such as those sold on the exempt market are highly speculative and very risky. They should only be purchased by investors who can afford to lose all of the money they have invested. DiversificationDiversification A way of spreading investment risk by by choosing a mix of investments. The idea is that some investments will do well at times when others are not.
May include stocks, bonds and mutual funds. The equity premium Treasury bills issued by the Canadian government are so safe that they are considered to be virtually risk-free.
The government is unlikely to default on its debtDebt Money that you have borrowed.