An explanation in the CFAIs text has made my understanding of the concept of equity risk premium a little shaky. Here is the question. If there is a war in the country from year 2004 to 2006 and the war affects country’s financial industry , its return and the overall economy. Now lets suppose, I am measuring equity risk premium for the period 2004 to 2006 today based on the historical data. What will happen to the ER Premium ? My Explanation: Since there was a war and financial market and its return was affected, investor would demand higher returns to compensate them for the additional risk and hence Equity Risk Premium based on historical events would be higher. Am I right guys ?
If war is not over - Then higher risk premium is justified. But if war is over, then you will have to lower the risk premium to avoid bias towards that period.
Yeah agree with that. But what if I want to measure the equity risk premium only for that period in which war was there (2004-2006) ? Then ER Premium would be higher isn’t it ?
no it would be lower bc the return on the equity index would be lower due to inherit global risk putting pressure on indexes, not really hard to believe, watch The Talking of Phelm 123, “terroirst” take over NY subway, equities tank, gold futures up!
So there would be two effects. 1. Returns on indexes will be lower due to the effect of war (increased risk)- Decrease in Equity Risk Premium. 2. Premium demanded by investors over the returns of index would be higher - Increase in Equity Risk Premium. Now which one will be greater than the other ? PS: If you wanna know the exact question : CFAI Book 4- Equity , Page no. 149 - Question 8. If you get the explanation, then do tell me.
number 1 would be bc the premium might not be realized, yes its demanded but the mkt will not provide it given depressed levels during war
2010L2 Wrote: ------------------------------------------------------- > So there would be two effects. > 1. Returns on indexes will be lower due to the > effect of war (increased risk)- Decrease in Equity > Risk Premium. > 2. Premium demanded by investors over the returns > of index would be higher - Increase in Equity Risk > Premium. > > Now which one will be greater than the other ? > > PS: If you wanna know the exact question : CFAI > Book 4- Equity , Page no. 149 - Question 8. If you > get the explanation, then do tell me. The answer is B, just think about DDM - increase risk premium decreases returns. Can’t say one is greater then the other, they both work in unison. 1) war usually ends, thus not consistent 2) nothing else is happening to offset the decrease …erm…remember back to 2003. stocks dropped b/f invasion, then as optimism of a win increased, equities picked up. 3) unless war affects an economy directly (dustruction of industry) then its adverse affects don’t really represent true business conditions. they will be undervalued.