Possibilities of application CAPM to Polish stock exchange market with help of implited market risk premium

Abstract

This paper is prepared to evaluate the market risk premium for Polish stock exchange market. Market risk premium (MRP) is a central component of every risk return model. Professor Ivo Welch from the University of California believes that MRP is in the forefront of all the numbers in finance. It is the difference between the return on stocks and risk free assets. The research is based on Capital Asset Pricing Model as it is the one which is the most popular and most commonly used for equity premium calculation. The main purpose of the work is to show that traditional method of estimating MRP, with help of historical data for Polish stock market, is pointless when it comes to accurate results and to propose alternative way to obtain it through Dividend Discount Model (DDM). Looking at many researches gathered especially by American scientists we may say that the market risk premium based on historical data is not applicable to Polish stock exchange market as well as to other emerging markets. More and more scientific conferences discuss the issue of market risk premium and that is why the problem is getting more significant for all the investors all around the world. The idea of estimating MRP in Poland is not very common, that is why the topic seems to be interesting and worth examining. To inspect market risk premium we need to use Dividend Discount Model so as to receive cost of equity for the equivalent of the market and then Capital Asset Pricing Model for a premium itself. There are few methods for MRP evaluation but DDM is the most popular and the most recent, that is why it was used in this paper. The work is divided into 4 chapters. The first chapter defines portfolio theory and the background of Capital Asset Pricing Model. The second one discusses in details market risk premium as a central component of CAPM and the most questionable factor, as well as the ways of receiving it. The third chapter shows MRP results prepared and published by the financial scientists for US well-developed market. The fourth chapter is the comparison between traditional and alternative way of receiving MRP for Polish stock exchange market.