I came across a question, and in the question it was given that markets are overvalued by 3%. Then in the application of the Ibotsen-chen model, in solving for the required rate of return, it comes out to:
req= yield - RFR + {1+expected inflation)(1+expected real GDP)(97%)-1)}…
Why does the factor go to .97 and not 1.03…if markets are overvalued by 3%, shouldn’t we pay less, therefore the requried calc should come out to be higher? Multiplying by .97 makes the req lower here, indicating we’d pay more for an overvalued market? I must be missing something…
Thanks!