Economic outlook impact on equity risk premium

CFA Level III Economics
#1

Study session 6, reading 17, Example 33 (Blue Box question, solution to Q1)

If the overall economic outlook is positive (implying equity markets are expected to perform well), is the equity risk premium (premium over risk free bond) expected to increase or decrease? In my view it should decrease because investors would demand a lower risk premium due to lower risk, and this would in turn improve equity valuations. In a blue box question, the curriculum claims ERP will ‘increase’ if economic outlook is positive, and I don’t understand why that would be the case.

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I posted it on a friend’s behalf. Will get the reference tonite. Thanks for everyone’s input.

#2

Which blue box problem are you referring to? (page number & volume)

#3

it should increase - if nothing the yields on bonds will reduce making money cheap for investing…also this is a typically low interest rate environment.

#4

Reference ?

#5

Rates won’t go lower in good economic environment they will rise. Yields on bonds will move up most likely

#6

OP might be reffereing to p. 94 Volume 3.

I would think ERP will increase during strong economic growth. The equity risk premium is the premium investors receive for taking equity positions, wouldn’t the premium be higher when times are good. I think we confuse it with the required return on equity (I think).

If I remeber, in emerging markets risk premiums increase during high growth, and then fall as the market matures and has lower rates of growth. It also probably falls because it becomes more integreated with the global economy due to the less than 1 correlation.

#7

Updated. Please take a look.

#8

Interesting question. I’m thinking - given a positive economic outlook, expected returns would increase…and at a rate above the increase of the risk free rate. So, the difference between expected returns and the risk free rate widens --> increase in the ERP. The assumption here is the difference in the rate of increase between returns on equities and the risk free rate. But I think that’s explained by the nature of equities and having a positive sharpe ratio. Also, as yields on the risk free asset rises, the value of the asset declines, which will work against the holder, on a total return basis. Feel free to critique anyone…pretty much throwing some ideas out there.