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How do you calculate each of the five risk factors in your equity risk premia model?


We use fundamental analysis to determine the five factors that are included in our asset pricing model. The five factors we use are Size, Leverage, Profit, Investment, and Term Spread. The first four factors are extracted from the company’s financial statements at each reporting date. These factors can be explained as follows: 

  1. The Size risk factor is calculated as the Total Assets of the companies, measured in USD. We use the logarithm transformation for this.

  1. Our measure for the Profit risk factor is calculated as Operating Profit Margin, which is the operating profit (Profit before Taxes)/ Revenues. We measure revenues as the sum of the operational and financial revenues. 

  1. The Investment factor is the percentage of Capital Expenditures (cap ex) to the total assets. 

  1. The Leverage factor is the ratio of the current and non-current liabilities (Total Liabilities) to the total assets of the firm. 

  1. And finally, the Term Spread is the difference between a risk-free long-term bond (20 years) and a risk-free short-term asset (3 months) for all the companies on each reporting date. The Term Spread risk factor can furthermore be used as a proxy for country risk. 

Further Reading

A comprehensive explanation of our Equity Risk Premia approach, including our five factors, can be found here.

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