Reading 35 Practice problem #8 from CFAI text

CFA Level II Equities
#1

I’m am looking for help on practice problem number 8, from reading 35, return concepts. I do not understand why the ERP would have an downward bias. As I understand ERP, the bias should be upward for a period of disruption in the equity markets. Did anyone else have trouble with this problem? What am I missing? The answer provided in the text did not clarify to me why it shoud be a downward bias. Thanks in advance for any comments regarding this question. -Mark

#2

Equity risk premium is the access return of market over risk free rate. The events of 2004 and 2006 have disrupted the economy and financial markets which imply that the stocks would be depressed and generating less returns making the equity risk premium to be less than what it should be. Moreover those events were not offset historically and the factor was not persistent, making the historical equity risk premium less than what it should be & biased downwards.

#3

Thank you for the reply. I’m still not sure I agree. On page 60 and 61 of the Equity CFAI book: “The ERP is coutercyclical in the US–that is, the expected (equity) premium is high during bad times but low during good times” The answer does not seem right to me. Also, logically you would expect a “risk premium” to be higher during times of uncertainty. The rate is relative to Tresuries, so just becasue equity returns decline doesn’t in itself imply the ERP declines.

I know the question isn’t based on the US, but I still don’t see what I’m missing. Oh well, moving on. Too many other things to cover. Thanks again for taking the time to reply Belaal.

-Mark

#4

Mark,

It is similar to bonds - inverse relationship between prices and yield. When times are bad, market is down, expected return is high. Stated differently, at bad times, investors would demand a higher risk premium pushing the price down (inverse relationship between price and required rate of return).

#5

The historical data series from which the ERP is calculated contains an abnormal event that was not offset and does not reverse. Therefore the low market returns of the abnormal event places a downward bias on the ERP that was calculated from the data series.

#6

We use historical risk premiums to get an idea of what risk premium we should use in the future. The way I see it is if risk free rate remains the same and the overall market rates have depressed it means that the risk premium (during those times) have reduced and if we take a mean value of ERP then it would be biased downward because the ERPs during those period would be less than what they should be under normal conditions.

#7

This has nothing to do with historical ERP. It has everything to do with the expectations built into CURRENT prices…