A particular problem on the CFA curriculum asked us to calculate the equity risk premium due to macroeconomic factors from the Ibbotson-Chen model. I know one of the variables is the risk free rate, but in the specific problem I am looking at there is one short term risk free rate and one long term risk free rate.
The answer incorporated the long term risk free rate. I am wondering why this is the case? I thought we were supposed to use the short term risk free rate (which is what I believed in used in the CAPM and Fama French models).
The Fama-French model uses the 1-month T-bill rate as the risk-free rate.
Why? Because Messrs. Fama and French decided that that’s what they wanted to use.
The curriculum does not specify whether the risk-free rate for the Ibbotson-Chen model should be a short-term rate or a long-term rate; however, they do use 20-year T-bonds and 20-year TIPS in their example to determine expected inflation, so that may suggest that you look at a long-term risk-free rate.
How about the growth in EPS. A specific problem that I am looking at provides the EPS growth rate, but the book says that in the long term that EPS growth rate should equal the GDP growth rate.
As such, if the problem provides both the EPS and GDP growth rates, should we use the GDP for the EPS growth rate? Since it seems like all the variables in this model resort towards using long term aspects of each variables (long term inflation rate, long term risk free rate, etc.)
Is this confirmed? I ran into problem on CFAIthat was doing CAPM… They had two rates listed in the problem: The 90 day tbill and a 2 year bond… The solution said CAPM uses long term rates… but I thought 2 year is not long term still lol. 10 years is long term.