An equity index is established in 2001 for a country that has relatively recently established a market economy. The index vendor constructed returns for the five years prior to 2001 based on the initial group of companies constituting the index in 2001. Over 2004 to 2006 a series of military confrontations concerning a disputed border disrupted the economy and financial markets. The dispute is conclusively arbitrated at the end of 2006. In total, ten years of equity market return history is available as of the beginning of 2007. The geometric mean return relative to 10-year government bond returns over 10 years is 2 percent per year. The forward dividend yield on the index is 1 percent. Stock returns over 2004 to 2006 reflect the setbacks but economists predict the country will be on a path of a 4 percent real GDP growth rate by 2009. Earnings in the public corporate sector are expected to grow at a 5 percent per year real growth rate. Consistent with that, the market P/E ratio is expected to grow at 1 percent per year. Although inflation is currently high at 6 percent per year, the long-term forecast is for an inflation rate of 4 percent per year. Although the yield curve has usually been upward sloping, currently the government yield curve is inverted; at the short-end, yields are 9 percent and at 10-year maturities, yields are 7 percent.
- In the current interest rate environment, using a required return estimate based on the short-term government bond rate and a historical equity risk premium defined in terms of a short-term government bond rate would be expected to:
- bias long-term required return on equity estimates upwards.
- bias long-term required return on equity estimates downwards.
- have no effect on long-term required return on equity estimates.
The answer is A. I had the answer down as B because the short term rate is higher than the long term treasury rate. If you were to use the long term treasury rate the required return and the risk premium would be higher. what is this question actually asking? Can someone explain why its A?