The Annual Survey of Professor Pablo Fernandez: Market Risk Premium and Risk-Free Rate 2015

This year I was included in the Annual Survey of Prof. Fernandez on market risk premium and risk-free rate. I found the papers of Prof. Fernandez in SSRN ten years ago. I was fascinated by his critical, restrained, wise, and unbiased view on valuation. I like his style on valuation more than that of Prof. Damodaran. I read Investment Valuation in 1997. It took me a week and I liked it. I could not believe that valuation is so easy and funny. I am grateful to prof. Damodaran but I keen on the Spanish & LatAm School on Valuation leaded by Fernandez, Estrada, Rojo-Ramirez, Montalvan, Sarrio, Canadas, Sabal, and Pereiro when it comes to valuation in emerging markets.

In my practice as a business consultant and university professor, I use the CreditSuisse Global Investment Returns Yearbook as a main source of market risk premium data. There are three reasons for this: (1) the methodology behind the Yearbook is rigorous. It is based on the work of Dimson, Marsh, and Staunton(2002); (2) The Credit Suisse Research Institute updates the Yearbook annually; (3) it covers the most important developed and emerging markets; and (4) it is free of charge. Regarding the risk premium of the Bulgarian stock market, I developed a simple methodology for historical market risk premium calculation.

To be or not to be? That is ... a (real) option.

Prof. Jamie Sabal shared the story of Panchito in his blog. In brief, Panchito Eché is a citizen of Cuba. He managed to save a small amount of money and is considering starting a small restaurant in Havana. The return from the business is promising about 15%. However, Panchito will face another problem. He should keep government officers happy. In other words he should share his happiness (profits) with the officers. Thus the return will be 8 % annually. Panchito's cousin who lives in Miami, told him that the restaurant business usually yields 12%. Since Panchito´s restaurant will yield 8% the NPV would be negative and the idea of opening a restaurant would have to be rejected.Thus Panchito has no choice but to "save" his money under the mattress at 0% interest.

Prof. Sabal concludes that the "NPV rule applies virtually everywhere".

The entrepreneurship and ingenuity could not be killed by any political regime. Panchito deserves the respect of all entrepreneurs in the World. Keeping the money under the mattress at 0.00% yield has another risk. Panchito is likely to be a victim of a robbery. Thus, he will lose his savings. Runing his small business he diminishes the risk of a robbery. Moreover, the happiness of the government officers could be classified as transaction fees or a premium of a real call option. In other words, Panchito starting the small restaurant in Havana is buying a real call option. The Government (officers) sells and he buys the right but not the obligation to start a small restaurant. Cuba is developing. Panchito believes that one day he will run his restaurant as a free entrepreneur like his cousin from Miami and he takes the challenge, the risk, to open the restaurant.

Real options can be found everywhere. Panchito has the eyes to see the option for expansion and willingness to exercise it.