Depressed returns. Effect on Equity Risk Premium


I am struggeling to understand the effect of periods with depressed returns will have on Equity RIsk Premiums.

My thought process is that during bad times an investor demands a higher risk premium to be invested in equity. So I would have believed that if we include periods of depressed returns, the equity risk premium would be biased upwards?

The CFAI books tells me differently: [content removed by moderator]

How come the period from 2004-2006 with depressed returns bias the equity risk premium downwards? Where am I going wrong in my thought process? Thanks for the help, much appreciated.

Not entirely sure of the context as I don’t know what question you’re referring to, but if I am right in my assumption that the question refers to an estimate of ERP using historical data then the downward bias could be driven by poor returns across equity markets reducing the return differential relative to government bonds. Remember that the historical estimation method estimates the ERP based on the difference between the average return on equities and the average return risk free asset.

This used to confuse me a lot too but the easiest way to think of it is like this:

The ERP is the (RM-RF).

Now, when you think of any situation think how it impacts this formula. So let’s say share returns were depressed. What does this do to the formula above. Well, RM goes down. Therefore the number is biased downards. So how do we adjust it, we adjust it upwards back to its normal state. Think of it as a mean reversion. Too high needs to come down, too low needs to come up

Play around with different conditions and see how it impacts that formula, it should make the solutions clear.

Fantastic explanation, using the formula was an excellent idea. Thanks a lot!

Thank you studyguy18, put my thought process on the right path. Much appreciated!

Hi, I thought I had understood Equity Risk Premiums by now. In good times the Equity Market will perform better. I.e. Equity Risk Premium goes up. ERP = ERM - RF. Then in reading 50, I came across this statement ’

"Price multiples are positively correlated with expected earnings growth rates and negatively correlated to required returns. Therefore, price multiples rise with increases in expected future earnings growth and with a decrease in any of the components of the required rate of return (the real rate, expected inflation, the risk premium for inflation uncertainty, or the equity risk premium). A s a result, the equity risk premium declines during economic expansions and rises during recessions."

Which again is opposite to the ErP = ERM - RF.

Any comments?

Hi, someone can help explain this question again to me? As I still think that the ERP is higher during bad times, so including this depressed time period would have a upward bias problem.

One paragraph in the book says " Empirically, the expected equity risk premium is countercyclical in the United States—that is, the expected premium is high during bad times but low during good times." So, if this is the case, then including the ERP from 2004-2006 would cause upward bias?

So, if someone can give a different perspective to clarify this logic to me? Much appreciated.