Question

Hi, in regards to the paper on risk-free rate (Dec 08), i don't really get it on why equity risk premium rises when Rf rises? I thought ERP is supposed to drop if we follow this formula ERP = Equity return - Rf. Is it assumed that Equity return moves in tandem with the Rf?

Answer 1

So, let's say the riskfree rate is 3% and you demand a return of 8% on equities. Let's now say the riskfree rate is 7%. Would you settle for 8% still on equities? I would not. In fact, I would not even settle for 12% (which would keep the risk premium constant). I would demand 13%, 14% or higher...These numbers are not fixed numbers. They reflect expectations and risk aversion...

Answer 2

haha, thanks for knocking some common sense into me. well, iow, why would one go for a equity returning 8% (with all the risk/troubles involved) when you can go for a risk-free one at 7%? Obviously we would want a much higher premium on the return. Thanks again!

Answer 3

I second gloomberg. expected return on equity should be greater when risk free rate increases but I don't think it is intuitive to say the risk premium increases when the risk free rate increases. For example after the financial crisis the risk free rate reached his lowest levels but the risk premium increased. if the risk free rate is high from an economics point of view this means that the central bank is trying to control inflation and that the economy is booming. So I think the risk premium should be lower when the risk free rate is higher . On the other hand when the risk free rate becomes lower this means that the central bank is trying to help people to borrow and trying to boost the economy (i.e the economy is riskier and equity risk premium should be higher).

Answer 4

Using a crisis to form long term predictions is a recipe for disaster. Across time, it is an empirical fact that higher riskfree rates go with higher risk premiums... After all, the biggest factor behind movements in riskfree rates is expected inflation.. and higher inflation makes risk premiums rise across the board.

Answer 5

thanks alot for this is an in depth remark