Guys,
When are you doing your Discount Rate Calculation. For your Market Risk Premium, Which method do you use for the past Market Returns.. Geometric or Arthemetic?
Which method is better and if some can please explain me why? All your input will be appreciated.
Thanks
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The geometric average takes historical returns (empirical data) and arrives at a compound rate of return which equates the initial and final values regardless of the given time period.
i.e. If you start with a $100 investment, experience significant volatility in the stock price over the holding life, but sell at your purchase price the return is still 0%.
Arithmetic is a simple average, not independent of the time interval and is a better proxy for future expected returns.
You want to use the geometric mean. The geo mean is used for multiplicative averages (like rates) and the arithmetic for most other situations, in general. The arithmetic mean will overshoot in situations where the geo mean should be used. If you want the math behind the reasoning, google.
Geo underestimates the short term Arithmetic over-estimates the long term
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