In CFAI Equity Topic Test - Rivera, Question 3, why is Caveat 2 correct? Equity Risk Premium for based on long term gvt bonds is smaller than short term gvt bonds, that should be wrong no? Because long term bonds needs to account for illiquidity and uncertainly?
Although I don’t have the question, if I understand you correctly, this should be the reason: since long term gvt bonds as you said accounts for liquidity, uncertainty etc it generally yields more than a short term bond. And gvt bonds yields are risk free rates. Higher the risk free rate (long term bond), smaller is the ERP since rm-rf gets shrunk. The opposite is true for short term gvtv bonds.
I just noticed I made a typo in my question, which is comparing Equity Risk Premium based on LT government bonds vs. that based on ST gvt bonds. Again I still dont know why is it so. Maybe as you said, LT government bonds already comprise liquidity and uncertainly, hence the premium is smaller?
Equity risk premium is Rm-Rf for long term bonds you require more premium because of uncertainty as compared to short term bonds, so for long term bonds RF is higher as compared to short term beacuse of which Rm-Rf is lower.
That’s exactly what I thought but the answer says Rm-Rf is smaller for long term than for short term.
It is correct. Rm - Rf is smaller for long term. Say LT rates are 10% and ST rates are 5% and Rm = 15%.
For LT, Rm-Rf = 15%-10%=5%…For ST, Rm-Rf=15%-5%=10%.
Ok I got it. Thanks Amruth!