Military Confrontations

Question

I've gone over this Q 3x and always get it wrong.

CFAI Equity, Vol. 4, Reading 31, p.86 EOC Q 8

Vignette:

"Eq. index is est'd in 2001 for country w recently est'd mkt economy. The index vendor constructed returns for the 5 yrs prior to 2001 based on the initial group of co.'s constituting the index in 2001. OVer 2004-2006 military confrontations disrupted the econ. & mkts. It ends in 2006. In total, 10 yrs of eq. mkt return history is available in 2007..."

That's all that seems relevant to Q #8.

Q 8. "The events of 2004-2006 would be expected to:

A. bias the hist. eq. risk premium est. upwards.
B. bias the hist. eq. risk premium est. downwards.
C. have no effect."

Picked A 3x.

Answer: "B is correct. The 04-06 events depressed returns but 1. are not a persistent feature in the stock mkt 2. were not offset by other positive events with the hist. record, and 3. have led to relatively low valuation levels, which are expected to rebound."

Now, this may be minute but there's a relationship that I'm missing.

I do not understand CFAI's explanation.

My thinking: If bad things happened in country, then  eq. risk premium (ERP) goes up.
If bad things happened a while ago, then bias ERP upwards for that time period.

What am I missing?

Thanks!

Sophie Macon · Answer

Indeed - Level 2 is a lot of sticking all the various concepts you've learned in the same item set!

Sophie Macon · Answer

Misleading title @ykilstein! :))

Indeed this is a tricky question, but I don't think I have the full question here as I suspect it's a matter of wording in the question.

Your reasoning makes sense, but based on your interpretation of the question. Would you mind taking a picture and uploading it to imgur.com, using that image URL to put it here for all to see?

You are right that in turbulent times, ERP would be biased higher. Based on the answer, I suspected the question is asking what the analyst has to do as an ADJUSTMENT to this one-off event (correct me if I'm wrong, I'll know once I see the full quesiton) - hence the answer for B (to adjust it downwards to avoid that one-off bias).