Hope someone can help me out. Equity book, Rd. 35, pg.148, Q7&8. Question 7. The answer in the book is A. I chose B. Adding in survivorship bias brings down the equity premium not increase. My thinking is if there are strong/healthy companies, doesn’t this reduce the equity premium? Question 8. The answer in the book is B I chose A. Doesn’t military confrontations, even for short periods, skew the equity premium upwards? Thanks in advance.
when there are strong companies left behind - their equity risk premium would be higher. the ones with lower are all gone. bad data has been removed. military confrontation is a series of negative surprises. So erp would be biased downwards because of that
Thanks for the quick response. That does not make sense in my head. For strong companies, shouldn’t their equity risk premium be lower? Investing in a strong company should have a lower risk than investing in a weak company. My required return should be higher to compensate for the weaker company (higher equity premium). In my eyes, this is the same with military confrontations. This is a bad thing, therefore the risk is higher to invest during this turbulent time. Shouldn’t the risk premium increase?
erp=return of mkt - risk free rate- i f companies are strong return on mkt will be high thus high erp. if there is military action return on mkt will be low- thus lower erp
it is not the effect due to the good / bad companies present. when there is survivorship bias - and only good companies are left behind - your erp is lower. granted. so rather than use the historical estimate of the erp seen from your sample - you should adjust it upwards to reflect what it would have been if more companies, both good and bad had been in the sample you were looking at. When there are military confrontations - erp would be biased higher. to reflect normal times - you need to adjust it DOWN! the question is asking what would be adjustment you as an analyst would make when you see the erp as provided by the sample… in both cases.
cubsfish - Thank you very much for your post! Makes sense. CP - Reading your post now makes complete sense. Thanks again! Gotta love AF for the quick responses.