Should I use long term rate or short term rate for the risk free rate in computing equity risk premium?
A studying note stating that the (Gordon Growth Model)GGM should use a long term rate, while other models should use short term rate.
However, I note that some examples for supply-side estimate( Macroeconomic Models) use long term rate for risk free rate in computing equity risk premium.
Please help.
I had the same question and the CFAI curriculum does not specify. I think they would probably mention it in the question because I have seen both being used.
If in doubt, use the long term rate unless an equation specifically calls for otherwise. Usually this will result in a higher risk free rate used. Which makes sense because why would equity be marked up from a lower risk free rate if a higher risk free rate also exists. I guess they could throw a scenario where there is some market stress and an inverted yield curve (short term rates higher than long term). But when that happens you’re usually supposed to look at the long term picture anyway. Because equity has an indefinite life in theory, not a short term life. Equity risk premium is - unless the equation dictates otherwise - a long term prediction of how equities are priced at a premium to risk free assets.
The question may have some specific clue that they are asking about only a short window of time. In which case they should be clear about that. In such case you could perhaps look at the risk free rate that fits that time period. But there will be tips in the question, if so.