reverse yield gap

I don't quite understand the use of the reverse yield gap (GRY-d=IRP-ERP+g).

Can anyone explain this to me?

If reverse yield gap above normal:

Assets fairly pricedexpected return = required return)
IRP and g are high
ERP is low

Assets not fairly pricedrequired return <>expected return)
government bonds are relatively cheap to equities.

Thanks a lot

 

The key thing to remember is that the equation you have quoted only holds if the market is in equilibrium (when asset prices reflect investors' opinions and are therefore 'fairly priced').

We assume that asset prices usually do reflect investor's opinions. So when the value of GRY-d is higher than usual, this could either be because the equation still holds, but investor's opinions have changed (in which case assets are fairly priced), or because the equation has ceased to hold (in which case assets are not fairly priced).

For example, if investors think that dividends will grow at a higher than usual rate, prices of equities will increase and dividend yield will fall. This will increase the value of GRY-d.

Alternatively investors could still think that dividends will grow at the usual rate, but equity prices are higher than usual. In this case, the equation will not hold.

Hope this helps. I know I probably haven't explained this perfectly.



Sam