Help! An Equity Question

CFA Level II Equities
#1

Hi guys,

a question on the textbk excercise, (Reading 31 Problem 9)

Currently the short term government bond yield is 9%, while LT government bond yield is 7%.

Q: using the ST government bond rate and a historical quity risk premium (defined in terms of ST government bond rate) to estimate required rate of return, it would

A; bias LT required return on equity estimates upward.

Why?

Re=Rf+ Beta* (Rm-Rf)

A higher Rf will increase first part but decrease the second part, with Beta unknown, how can we know it is upward biased or downward?

Thanks for sharing your thoughts!

#2

Rm > Rf always unless otherwise told so. Therefore the ‘impact’ of the first RFR in your formula influences E® the most. using the short run yield biases it upward.

#3

I guess we can think it intuitively,

current inflation is high and overall short term rate is high, so your required return based on short term should be higher than long term( lower inflation and lower rate)