CFAI Volume 3 Pg 97 Capital Market Expectations " Client asks Wu to help him decide based on the economic analysis whether a 1% or 2.5% equity risk premium is more likely" … … “Overall, a 2.5% Equity Risk Premium appears to be justified by the POSITIVE economic outlook” Ok, so this is confusing to me, I figured just the name itself should have made this easier. i.e Equity RISK premium. If the future outlook of the economy is supposed to be good, doesnt this mean that there should be a lower risk to holding these specific securities therefore having a lower risk premium , therefore choosing the 1% erp for the answer to the question?
The way I see it, ERP as the premium added to a risk-free rate, and in a poistive economic environment you expect higher returns from equities for which you should be paying a higher premium. (Although I do agree that this is very confusing, as a higher discount rate implies lower present values)
ylager Wrote: ------------------------------------------------------- > The way I see it, ERP as the premium added to a > risk-free rate, and in a poistive economic > environment you expect higher returns from > equities for which you should be paying a higher > premium. Isnt it the opposite though? i.e an investor DEMANDS higher premiums in RISKY environments. ( i.e you want me to take risk by holding a risky security, then there better be a higher spread above the risk free rate to compensate me, hence the higher ERP). But in this example, if there is positive information on the economy, this means these equities are deemed safer, therefore investors dont need to demand higher premiums to hold these securities. ???
Remember, this is expected return. So in the good times you expect equities to grow fast than in bad times. Don’t focus so much on the RISK, focus on the fact that in good times investors will be bullish and bid up prices on equites while they leave bonds and the prices fall.
It’s self-explanatory once you realize that discount rates are a way of quoting opportunity costs.
It is all about expectation. ERP is the expected excess return from equity mkt over the long term risk free rate. When the economic outlook is positive, investor will expect a higher risk premium. Likewise when the outlook is negative, we should see a lower risk premium and hence a lower cost of equity.
As an interesting side note: Positive economic outlook may imply that things are not so good right now. When things aren’t good, interest rate is low, so you want a higher return in equities to justify the risk. When we are at a full economic boom, rates should be higher, then I can see the ERP may actually be lower.
Equity Risk Premium from CAPM = (Expected market return - Risk free rate) In a good economy lookout, expected market return would be higher and hence Equity Risk Premium would be higher.
On page 35 V 3 the equation for calculating expected return on equity one of the terms is -change S. Can someone explain when you add to D/P and when you minus form D/P.