Risk Aversion and the Equity Risk Premium

Case Study

On the advice of some of its wealthiest alumni, College has borrowed £15m on a 40-year inflation- linked loan. One year, as any beleaguered banker will tell you, is a long time in the markets. Banks crash, governments bail out and the landscape of the City shifts forever. But in the cloistered colleges of Cambridge University it's a mere blip in financial history and the brightest academics in the land are banking on the good times rolling round once again.

 College, Cambridge is attempting to cash in on the current economic crisis by borrowing money for the first time in its 700- year history to take advantage of cheaper shares. On the advice of some of its wealthiest alumni, it has borrowed £15m on a 40 year inflation- linked loan, which, it hopes, will one day in the distant future reap a profit of £36m.

Only Oxbridge with its bulging endowment coffers could afford to squirrel away £15m over such a long period of time, as Donald Hearn, colleges' bursar freely admits. "Because we have a very, very long term perspective - we've been around for 700 years and plan to be around for at least 700 more- we have the advantage of not worrying about short term thresholds," he said. "We are putting the £15m away for 40 years and will not touch it for all that time."

The college has borrowed the money at a real rate of interest of 1.09% to invest it in rock-bottom stocks and shares. The length and type of loan makes it the first of its kind for any British or American college, according to HSBC, who did all the work on the deal. Rather than a conventional loan paying back the same amount of money in 40 years plus interest, the inflation-linked loan means the college will have to pay back an estimated £70m in 2052 but with a projected profit of £36m.

"Because real interest rates adjusted for inflation are so unusually low it happened to be one of those occasions where we could borrow at 1.09% and it's almost inconceivable that real returns on equities will average less than 1.09% over the next 40 years," Hearn said.

Because UK institutions have been forced to match their long-term liabilities very closely, long-term inflation-linked yields in the UK are very low. The real yield on the 2052 I/L gilt is 0.8 per cent per year. The real yields on comparable I/L government bonds in the US and France are 3.1 per cent and 2.6 per cent respectively.  is borrowing at 1.09 per cent (including a cap on its nominal liability at 7 per cent inflation). One Independent City expert told the Financial Times: "They are almost bound to make money, when you allow for rises in equity prices and dividends over the next 40 years." This belief is reinforced by college's view that stock markets are now at or near their bottom.

Required:

(a)  Critically assess the theoretical and empirical evidence for the belief that 'it's almost inconceivable that real returns on equities will average less than 1.09% over the next 40 years'.

(Your answer should include reference to risk aversion and the equity risk premium).

(b) Critically assess the theoretical and empirical evidence for the belief that the strategy outlined in the case is less risky over the long run than it would be over a short period of time.

 (Your answer should include reference to the arithmetic mean, geometric mean, and standard deviation in forecasting risk and return over different time periods; and the meaning and relevance to this particular case of 'mean reversion').

(c)  It is suggested in the case study that 'stock markets are now at or near their bottom' and 'they are almost bound to make money'. In relation to these statements, with relevant data and evidence, discuss to what extent market timing is feasible using:

(i) Reverse yield gap

(ii) Tobin's q

(iii) PE ratios

(iv) Charts, including moving averages

(d)  Discuss the theoretical and empirical arguments for Clare College including commodities as an additional long-term asset class.