FM Assignment-2

1.Calculation of ERP(6 countries)

2.Implied ERP.
3.Risk calculations.

BY:

Sampath Mylavarapu - 2017A4PS0692H

Sai charan reddy - 2017A4PS0667H
Vineeth Manyam – 2017A1PS0884H
Sirichandana Jagarlamudi – 2017B3PS1239H
Abhinav Gupta – 2017A4PS0629H
Shilpa Narlagiri – 2017B3PS1251H
 1.Equity Risk Premium(ERP)
The equity risk premium is the price of risk in equity markets, and it is
a key input in estimating costs of equity and capital in both corporate
finance and valuation. Given its importance, it is surprising how
haphazard the estimation of equity risk premiums remains in practice.
Equity Risk Premium is a premium that we as an investor demand for high risk
securities. It is dynamic in nature.

ERP= Spread of mature market + Country’s Default Risk premium

Default risk premium is the country’s risk premium which is given by:

CRP= Country’s Default Spread* (std. deviation in equity index/ std.

deviation in country bond)

The equity risk premium reflects fundamental judgments we make

about how much risk we see in an economy/market and what price we
attach to that risk. In the process, it affects the expected return on
every risky investment and the value that we estimate for that
investment.
Equity risk premiums are a central component of every risk and return
model in finance and are a key input into estimating costs of equity and
capital in both corporate finance and valuation.
ERP Calculations
1.Sovereign rating of country (moody’s rating)
2.CDS method.

Year Return on 10-year US T. Bond

2000 16.66%
2001 5.57%
2002 15.12%
2003 0.38%
2004 4.49%
2005 2.87%
2006 1.96%
2007 10.21%
2008 20.10%
2009 -11.12%
2010 8.46%
2011 16.04%
2012 2.97%
2013 -9.10%
2014 10.75%
2015 1.28%
2016 0.69%
2017 2.80%
2018 -0.02%

Geometric mean of the returns is found out to be 4.94%.

 ERP values based on Moody’s Rating

ERP = US Risk free Rate + Moody’s Rating based Default Spread

Developing Countries Moody’s US Risk Free Rate ERP

India Baa2 2.15% 4..94% 7.09%
Brazil Ba2 3.39% 4..94% 8.33%
China A1 0.79% 4..94% 5.73%

Developed Countries Moody’s

United States Aaa 0.00% 4..94% 4.94%
Singapore Aaa 0.00% 4..94% 4.94%
Japan A1 0.79% 4..94% 5.73%

ERP values based on CDS Spread

ERP = US Risk free Rate + Excess CDS Spread (Over US CDS)

Countries CDS Spread Excess CDS Spread (Over US CDS) ERP

India 1.85% 1.55% 6.51%
Brazil 2.87% 2.57% 7.53%
China 1.14% 0.84% 5.80%

United States 0.30% 0% 4.96%

Singapore 0.20% -0.10% 4.86%
Japan 0.44% 0.14% 5.10%
 2. Implied equity risk premium
There is an alternative to estimating risk premiums that does not require
historical data or corrections for country risk, but does assume that the overall
stock market is correctly priced.The advantage of this implied ERP is that it is
market driven and current and it does not require any historical data. Thus, it can
be used to estimate implied equity risk premium in any market. It is, however,
bounded by whether the model used for the valuation is the right one and the
availability reliability of the inputs in the model.

Parameters required:

1.Dividend yield

2.growth rate

3.Index value

4.Risk free rate

Step 1: We first calculate the Expected return on stocks(r ). For this we need the
cash flows.

Step 2: We calculate the risk free rate of return (RFR).

Step 3: Now, for implied ERP, we use the following formula:

IMPLIED ERP = r -RFR

In the attached Excel sheet , we have calculated the “r” value using cash flows .

We get the cash flows from dividends and ERR and inflation. The equation is as
follows: CF(R) = Dividends*[(1 + ERR+ inflation)^R]

Here, R - number of years.

For this work, we take 2010 as base year and we took values till 2018.

The following attached picture is a example of the flow process,

Calculation of ERP for NIFTY50:

VARIABLE INDEX
NIFTY LEVEL 10829.35
DIVIDEND YIELD 0.0134
GDP GROWTH RATE 0.08
GEOMETRIC MEAN OF GOI T BONDS RETURN 0.0656
CASH OF INVESTORS(DIVIDENDS+CASHBUYS) 145.11329

ASSUMED VALUE OF RISK PREMIUM BE = 0.049.

 YEAR 1 2 3 4 5
156.722 169.2 182.8 197.4 210.3
FUTURE VALUES 353 601 01 25 761
LAST TERM
PRESENT VALUES WITH 149.387 153.7 158.3 162.9 165.5
IMPLIED RISK PREMIUM 43 875 171 801 434
790.015
TOTAL 554

By using Excel solver to calculate implied ERP, we get expected return

BY SOLVER = 11.51%

THEREFORE, IMPLIED EQUITY RISK PREMIUM (IMPLIED RISK

PREMIUM- RISK FREE RATE) = 4.95%

ERP FROM NIFTY IT:

Variable Index
level of the NIFTY IT = 15632
current dividend yield = 0.04
current long-term bond rate = 0.0655
risk premium = 0.0491
expected growth rate in the long term = 0.0655
CASH IN INVESTORS 625.28

ASSUMED VALUE OF RISK PREMIUM = 0.0491

Column1 1 2 3 4 5
Expected Dividends = 650.2912 676.3028 703.355 731.4892 760.7487

Present Value = 619.856258 614.4796 609.1495 603.8657 598.6277

Intrinsic Value of Index = 3045.97869

Implied Risk Premium GIVEN BY SOLVER = 9.96%

Implied Risk Premium in current level of Index = return on equity - risk free rate = 3.30%
 Generating New index:
We considered;

10 Indian IT companies and 10 foreign companies and generated the new index.

 TCS – Tata Consultancy Services.

 Infosys.
 Wipro.
 HCL Technologies.
 Mindtree.
 Mphasis.
 Rolta.
 Tech Mahindra
 Oracle;

We took the market capitalization of each and every company from 2010 to 2018 and base
value as 1000 and we generated our own Index based on all these.

Year Our Index

2010 1000
2011 1175.80914
2012 1272.85522
2013 1412.33389
2014 1657.63574
2015 1641.09369
2016 1727.7593
2017 2577.27514
 Our Index
3000

2500

2000

1500

1000

500

0
2010 2011 2012 2013 2014 2015 2016 2017

ERP of newly generated index:

VARIABLE INDEX
OUR INDEX LEVEL 2577.275
DIVIDEND YIELD 0.0134
IT GROWTH RATE 0.04
GEOMETRIC MEAN OF GOI T BONDS RETURN 0.0656
CASH OF INVESTORS(DIVIDENDS+CASHBUYS) 34.535485

ASSUMED VALUE OF RISK PREMIUM BE = 0.0491

YEAR 1 2 3 4 5
FUTURE VALUES 35.9169044 37.35358 38.84772 40.40163 43.05198
LAST TERM
PRESENT VALUES WITH IMPLIED RISK
PREMIUM 34.2359207 33.93895 33.64456 33.35273 33.87729
TOTAL 169.049461

THEREFORE, ACTUAL ERP BY SOLVER = 9.82%

THEREFORE, IMPLIED EQUITY RISK PREMIUM (IMPLIED RISK

PREMIUM- RISK FREE RATE) = 3.27%
 3. Risk Calculations
We here, calculate the systematic risk (beta) by using the regression
analysis. While calculating the systematic risk, we do it 3 times by using
NIFTY50, NIFTY IT, newly generated index and we get to see the variation
of the systematic risk with change in correspondence index.
In the attached excel sheet, we have calculated the “Beta” value using
the regression analysis.
1.NIFTY50
A. TCS:
From the calculations done in Excel
Beta 0.445486266

R-square 0.004817235

Intercept 0.036106799

Jensen alpha = Intercept - Rf(1-beta)

Jensen alpha = -0.274420892

We get the Systematic risk (beta) as 0.44. It is the covariance of market

and stock return.
MARKET RISK = 0.0048,it cant be diversified and cant be eliminated.
FIRM SPECIFIC RISK = 0.98, this Can be eleminated.
JENSEN ALPHA = -0.27 , It tells the abnormal return of the stock. It assess
the performance of fund manager.
 B. INFOSYS
Intercept 0.013642913

R- square 0.139494967

Beta 0.635345848

Jensen alpha = Intercept - Rf(1-beta)

Jensen alpha -0.190563412

2. NIFTY IT
A: TCS
Beta 0.445471

R-square 0.004787

Intercept 0.036048

Jensen alpha = Intercept - Rf(1-beta)

Jensen alpha = -0.27449

B:INFOSYS
Beta 0.63806

R-square 0.139806

Intercept 0.013543
 Jensen alpha = Intercept - Rf(1-beta)

Jensen alpha = -0.18914

We get the Systematic risk (beta) as 0.63. It is the covariance of market

and stock return.
MARKET RISK = 0.13,it cant be diversified and cant be eliminated.
FIRM SPECIFIC RISK = 0.87, this Can be eleminated.
JENSEN ALPHA = -0.18 , It tells the abnormal return of the stock. It assess
the performance of fund manager.