Hi, just need some help understanding the rationale behind CFAI reading 28 “Return Concepts” EOC questions #8-9 regarding bias of equity risk premium and return on equity estimates.
I don’t know if I’m allowed to copy/paste straight from CFAI text…
But question #8 basically it asks the events of 2004-2006 would be expected to: bias the historical equity risk premium estimate up/down/nothing. The events of 2004-2006 is a series of military confrontations that disrupted economy and financial markets. The answer is “bias the historical equity risk premium downward” but i don’t understand why. If the military conflicts disrupt the markets, wouldn’t your risk premium go upward because you require higher return in exchange for the risk in those years?
Question #9’s background is a little long but it basically asks if series of situations like having an inverted yield curve will: bias long term required return on equity estimates upward or downward.
The answer is upward but i’m having trouble seeing the relationships of what causes what.
Remember you are looking at historical data, not expectations of future performance. It is correct that if you, as investor, perceive increased risk in a market, you will demand higher returns. However, this does not always hold in real life. Extraordinary macroeconomic events impacts the whole market, in this case negatively. Therefore, actual returns that will become historical data in the future are lower than returns in peace periods.
The relationship between equity prices and bond prices is supposed to be negative. An inverted yield curve can be interpreted as “investors expect that future market economic performance will be bad”, so equity risk premiums increase accordingly (higher required rate of returns on equities).
Also, you need to know that investors “move” between markets. When macro is going bad, equities are going to be bad in the future, so investors migrate to fixed income securities and also are more willing to accept lower rates, that’s why the yield curve inverts. Fortunately, the system is convergent, so lower rates now will be the fuel for cheaper financing of real projects in the future, therefore booming economy again.
Did you see that? We found economic cycles!
Also, I want to share with you the Alternative Markets increasingly presence nowadays. But nah, first pass L2.
when you refer to this relationship equity/bond, is there some equation you have to balance? The first that came to my mind was the CAPM… so you’re trying to keep the left side of the equation fixed , so the right so (required return) + beta(ERP) if one variable goes up the other needs to come down. Does that have anything to do with it?
CAPM is not a good model to explain this. Too simple and inaccurate.
I can tell you that the negative relationship between equity prices and bond prices has been seen empirically and explained by modern economics.
The financial assets in aggregate (world) have a current allocation. That allocation changes every second depending on the information flow. Some information makes investors to move their assets to other kind of assets or to other markets. One of the things found in history is that when equity prices goes up, fixed-income securities prices fall. The relationship must not be perfect, not 100% predictable. Other variables affect prices, not only interest rates.
If you need an equation to predict this negative relationship we talk about, probably you are made of maths good sign btw. However, sometimes, it is better to be intuitive and theoretically sound.
good sign btw. However, sometimes, it is better to be intuitive and theoretically sound.