calculating equity risk premium (CFA mock vs. CFA books) correct, reading, solution, question, afternoon

clearlycanadian

Hi guys,

I have a problem with the the question in the afternoon part of CFA mock exam, which gives historical equity nominal return, T-bill return and rate of inflation and asks to calculate the risk premium. The correct solution:
1+RP=(1+RR)/((1+RFR)*(1+inflation))

That would make sense, but there's a seemingly identical question in EOC of reading 52 in CFA Vol 4 (question 13, p.380) where the correct solution is given as 1+RP=(1+RR)/((1+RFR) i.e. here they don't subtract inflation premium and get a larger RP figure.

Am I missing something here is it a mistake on the CFAI side? My guess would be the answer in the exam was the right one...

bluejazzy

Beatnik Wrote:
-------------------------------------------------------
> Hi guys,
>
> I have a problem with the the question in the
> afternoon part of CFA mock exam, which gives
> historical equity nominal return, T-bill return
> and rate of inflation and asks to calculate the
> risk premium. The correct solution:
> 1+RP=(1+RR)/((1+RFR)*(1+inflation))
>
> That would make sense, but there's a seemingly
> identical question in EOC of reading 52 in CFA Vol
> 4 (question 13, p.380) where the correct solution
> is given as 1+RP=(1+RR)/((1+RFR) i.e. here they
> don't subtract inflation premium and get a larger
> RP figure.
>
> Am I missing something here is it a mistake on the
> CFAI side? My guess would be the answer in the
> exam was the right one...


I have the same problem and I have written to CFA about it. Yet to hear back from them. But, my guess is that the curriculum is correct since Treasury return is 'Nominal risk free return' not 'Real risk free return'.

mnieman

I'm not sure if T-bill return can be used here as a 'nominal risk free return' - it would be ok if we had T-bonds, but T-bills include only short term, but not long term inflation premium.

anish: would be great if you could post here any reply you get from CFAI - i'm really curious to get to the truth;)



Edited 2 time(s). Last edit at Wednesday, May 18, 2011 at 10:56AM by Beatnik.

dotamasta

Beatnik Wrote:
-------------------------------------------------------
> I'm not sure if T-bill return can be used here as
> a 'nominal risk free return' - it would be ok if
> we had T-bonds, but T-bills include only short
> term, but not long term inflation premium.
>
> anish: would be great if you could post here any
> reply you get from CFAI - i'm really curious to
> get to the truth;)


Good point. I will let you know.

Siddimaula

Beatnik Wrote:
-------------------------------------------------------
> I'm not sure if T-bill return can be used here as
> a 'nominal risk free return' - it would be ok if
> we had T-bonds, but T-bills include only short
> term, but not long term inflation premium.
>
> anish: would be great if you could post here any
> reply you get from CFAI - i'm really curious to
> get to the truth;)


The curriculum says that T Bill return is 'Nominal risk free interest rate' Vol 1, Page 257
Have no idea how short term - long term play out...