sept 2010 paper 2 Q 5(i)b

[r_v.s]

Would you please explain what it says, esp

This total return can also be expressed as GRY – inflation risk
premium (IRP) + equity risk premium (ERP).
IRP which applies to GRY’s on conventional bonds is less of an issue
for equities given the implicit inflation hedge. (i.e. total return on
equities = risk free real yield + expected inflation + ERP (where ERP
also covers any small IRP))
???

 

[Steve Hales]

Hi

The question gives us the equation

(1) GRY = risk free real yield + expected inflation + inflation risk premium + bond risk premium.

Assuming that equities are fairly priced (ie the expected and required returns are equal), then

(2) d + g = risk free real yield + expected inflation + equity risk premium.

By rearranging (1) and (2) we get

(3) d + g = GRY - bond risk premium - inflation risk premium + equity risk premium.

But with a government bond, the bond risk premium is zero, therefore (3) becomes

(4) d + g = GRY - inflation risk premium + equity risk premium

as given in the solution.

The subsequent statement about the IRP comes from the fact that equities typically offer a real return (whereas conventional bonds only offer nominal returns). Therefore the inflation risk premium is more of an issue for bonds because equities already offer some protection against uncertain future inflation.

Hope this helps.

 

[r_v.s]

Yes, indeed! Thanks very much!!