Can some one tell me how they estimated the historical ERP which is given in the solution as 2%.

I understood the supply side calculation for ERP.

Can some one tell me how they estimated the historical ERP which is given in the solution as 2%.

I understood the supply side calculation for ERP.

Line 7

“The geometric mean return relative to 10-year goverment bond returns over 10 years is 2 percent per year”

There you got that ERP is 2%

In question 10 you got that Ibbotson-Chen model gives a ERP of 4.3%

Also you have the current short-term and long-term goverment bond yields (9% and 7% respectively)

Therefore, using CAPM, your required return can be:

7% + 1 x 2% = 9%

or

9% + 1 x 2% = 11%

or

7% + 1 x 4.3% = 11.3%

or

9% + 1 x 4.3% = 13.3%

All required returns, using different calculations available, are at least 9%. Then C is correct

Does this mean that return is 2% above the government bond yield?

So 2% is the ERP based on Bond yield-risk premium approach?

Exactly.

You may be confused because the word “relative”. The sentence tells you that equity returns (geometric mean) over 10 years are above the 10-year goverment bond yield by 2%, so it is:

ERP = E(rm) - RF

ERP = 2%

Gain and save experience with this kind of “wordings”.

Regards.