Hi guys, I have a question about ERP. From my understanding, ERP is the premium which compensates for risk over the RFR. However, the EOC question # 8 for Ch 37 says the ERP would be biased downwards if we include the 2004-2006 time period (which is a high risk time). I would assume that since there is an increased volatility, including this time would mean greater risk and hence higher ERP. Am I missing something? I just don’t get the logic. Thanks
Well, it looks to me like equity returns during the period are lower than they would tend to be now. This would imply that using this data will cause the ‘spread’ of equity returns over those of the risk free asset to be smaller than it should be under current economic conditions. It doesn’t say that there was more volatility exactly, just that the markets were ‘disrupted’.
Markets wer overvalued -> ROE demanded was low -> ERP was low -> Including that period will push the ERP downwards