I’ve gone over this Q 3x and always get it wrong.
CFAI Equity, Vol. 4, Reading 31, p.86 EOC Q 8
“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?
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).
Thanks, @zee. I’ve been in marketing for a while. I play around with subject lines to send to…PM’s 🙂
@sophie, here’s the link for the full Q: http://books.google.com/books?id=XCL9bkrOrpcC&lpg=PA81&ots=6gcdZlnhLh&dq=CFA%20%22military%20confrontations%22%20%22equity%20risk%20premium%22&pg=PA81#v=onepage&q&f=true
It’s page 81 and the link should bring you to just above where the vignette starts. You can Ctrl-F for “military”.
They’re not asking what to do as an adjustment, rather what the bad times would do to the ERP. I do not understand the verbiage of CFAI and/or how it relates to the Q+A.
Analyst forums had the same Q but I don’t think they helped. http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91109385
Again, even though this seems silly (“So what’s 20 million people between warlord friends?”), there seems to be a crucial concept there. Like yields go up, bond prices go down. (Wait, I gt write that down…)
Oh right, ok I understand now. The key word is historical.
There is a fine distinction between an ERP at a point in time (which is an expectation), and the actual ERP over that time.
So when the military confrontations broke out in 2004, yes ERP will increase at that time, i.e. people expect increased risk in the economy and would want higher premium to compensate them for investing in stock market at that time.
But in 2007, when you look back, actual ERP over 2004-2006 is probably less than expected ERP at that time, as “stock market return during that period reflected setbacks” , i.e. underperformed, hence ERP= market return – risk free rate over 2004-2006 is smaller than average. So the events of 2004-2006 would be expected to bias the historical (actual) ERP downwards.
ERP is always a funny concept, as there is a difference between expectation (implied ERP) and actual ERP (historical). If you have time, Aswath Damodaran is a good source on this as he loves ERP and updates his paper on (implied) ERP annually. http://aswathdamodaran.blogspot.co.uk/2012/03/equity-risk-premiums-2012-edition.html
I hope this helps @ykilstein
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