Ben Jacobs, CFA, is attempting to calculate a historical equity risk premium. His first estimate uses geometric mean equity returns and long-term bond yields. His second estimate uses arithmetic mean returns and short-term bond yields. The effect of the changes in methodology in the second estimate, relative to the first, will:
Answer: both increase the size of the risk premium.
Switching from a geometric mean to an arithmetic mean will increase the mean equity return. All else being equal, that will increase the estimated risk premium. When the yield curve slopes upward, short-term bonds yield less than long-term bonds. Thus, the equity risk premium estimate will be larger when short-term bond rates are used.
Could someone please explain why the equity risk premium estimate will be larger when short-term rates are used?