Q on Equity Risk Premium

CFA Level II
#1

In computing a historic estimate of the equity risk premium, with respect to possible biases, choosingan arithmentic avergae of equity and treasury-bill rates would most likely A. Have an intermediate effect because using the arithmetic avergae whould tend to increase the estimate, and using the T-bill rate would tend to decrease the estimate B. Have an intermediate effect because using the arithmetic avergae whould tend to decrease the estimate, and using the T-bill rate would tend to increase the estimate C. bias the estimate upward because using the arithmetic avergae whould tend to increase the estimate, and using the T-bill rate would tend to increase the estimate What are they speaking here?

#2

C: 1) AM (arith mean) > GM (geo mean); hence when using AM over GM, you’ll have an inflated ERP estimate 2) Since yields are typically “normal” (i.e., not inverted); yields on bill < yields on bonds; hence ERP inflated once again if using T-Bills over T-Bonds.

#3

A

#4

C

#5

E(Rm) is being evaluated with Arithmetic Mean instead of Geometric Mean. So E(Rm) is higher because Arithmetic Mean > Geometric Mean. Rf is being evaluated with the TBill Rate instead of TBond Rate. With a normal upward sloping yield curve - TBond Rate > TBill Rate. So TBill rate will underestimate Rf. Arithmetic Mean will overestimate E(Rm) If we put on a time line kind of thing TBill--------TBond-------Geometric Mean-----Arithmetic Mean So ERP is being overestimated with using Arithmetic mean and using TBill Rate. So Choice C.

#6

CP explained it well but i feel like adding something on second point [T-Bill Rate] Look at it this way: Re = Return on T-Bill + Equity Risk Premium (ERP) Using T-Bill instead of any other rate, would make ERP higher.[assuming Re is fixed and given] If Re = T-Bond Rate + ERP , then T-Bond > T-Bill --> ERP should be lower… Does that make sense ?? Also AM >GM , hence Risk premium is high. First part of the question says---- Equity Risk premium is computed by taking historical arithmatic mean … Second Part says-- ERP is computed by using T-Bill Rate Question is asking impact on the value of ERP of the two methods used.

#7

I think the question is asking what the ERP would be if you used an avg of arithmatic mean and a tbill. So I thought if you use arithmatic it will be higher, and if you use a t-bill it will be lower (less risk)… whats the real answer?

#8

Thanks guys. C is the correct answer.

#9

EDIT: Deleted

#10

Option C. Arithmetic mean of market return is > geometric mean. So this component biases the estimate upward. EQUity risk premium = Rm-Rf. Using a T bill rate means Rf is smaller. So Rm-Rf is overstated as a whole.