Calculate Risk Premium? (CFA Mock 2011 Spoiler)

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anish

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CFA curriculum, Volume 4 Page 380 Questions 13 and 14 calculate Risk Premium as Return on Equities/Return on T Bills.
I get this.
CFA Mock 2011 Afternoon session Question 117 says that Risk Premium for Equities is Return on Equities/Return on T Bills*Inflation Rate
Any idea what’s going on and what is accurate? Am I missing something?
 
Seems reasonable right? In the denominator is the risk free real return available on cash and the numerator contains the return on equities. The ratio of those needs to be > 1 as the numerator is risky and the denominator isn’t.
I think I might change it into a % or something and maybe add some expectations.
 
Hi Anish,
Based on the formular in CFA Curriculum, Volume 4 Page 327 about nominal and real return, we will have:
[1+Risk Premium] = (1+ Nominal Return)/[(1+risk_free return)(1+Inflation rate)]
So I bet the answers and explaination in CFA Mock 2011 is accurate,
Btw, the answers on Question 13 and 14 in Volume 4 provide inaccurate formulars and the CFA errata version in February did correct them
 
i think the question in the mock is badly worded because clearly they are looking for the real rate of return, and the REAL risk premium. they should have made this clearer by repeating the word ‘real’. it tripped me up too.
 
JoeyDVivre Wrote:
——————————————————-
> I think I might change it into a % or something
> and maybe add some expectations.
You are killing me Jo.. I am just trying to somehow get thru Level 1…
 
Hai Hoang Wrote:
——————————————————-
> Hi Anish,
> Based on the formular in CFA Curriculum, Volume 4
> Page 327 about nominal and real return, we will
> have:
> [1+Risk Premium] = (1+ Nominal
> Return)/[(1+risk_free return)(1+Inflation rate)]
>
> So I bet the answers and explaination in CFA Mock
> 2011 is accurate,
>
> Btw, the answers on Question 13 and 14 in Volume 4
> provide inaccurate formulars and the CFA errata
> version in February did correct them
thanks Hai Hoang. Thats something I didn’t know… So I have a question for all 3 of you - Jo, Hai Hoang and Kiakaha - I know I am supposed to know it my now, but well, better late than never… Is treasury rate ‘real risk free rate’ or just ‘risk free rate’? I thought only TIPS give ‘real risk free rate’…. Treasury Bills give you the risk free rate which includes compensation for inflation… When I saw Q13, 14, I had got confused and then when I saw this question’s solution in mock, I again got confused…
 
hi Hai Hoang,
did you say the CFA errata version in February did correct the answers for questions 13 and 14 ? (the qns are on page 380 and the answers are found on page 385). i can’t find any such corrections under “Volume 4” in the February errata. could you please help me locate the corrections?
thanks.
 
you are right, treasury rate is just ‘risk free rate’ – apart from TIPs, as you point out. All other treasuries are nominal rates ie include compensation for inflation.
i couldn’t see those corrections in the errata either, any advice appreciated…
 
anish Wrote:
——————————————————-
> Hai Hoang Wrote:
> ————————————————–
> —–
> > Hi Anish,
> > Based on the formular in CFA Curriculum, Volume
> 4
> > Page 327 about nominal and real return, we will
> > have:
> > [1+Risk Premium] = (1+ Nominal
> > Return)/[(1+risk_free return)(1+Inflation
> rate)]
> >
> > So I bet the answers and explaination in CFA
> Mock
> > 2011 is accurate,
> >
> > Btw, the answers on Question 13 and 14 in Volume
> 4
> > provide inaccurate formulars and the CFA errata
> > version in February did correct them
>
>
> thanks Hai Hoang. Thats something I didn’t know…
> So I have a question for all 3 of you - Jo, Hai
> Hoang and Kiakaha - I know I am supposed to know
> it my now, but well, better late than never… Is
> treasury rate ‘real risk free rate’ or just ‘risk
> free rate’? I thought only TIPS give ‘real risk
> free rate’…. Treasury Bills give you the risk
> free rate which includes compensation for
> inflation… When I saw Q13, 14, I had got
> confused and then when I saw this question’s
> solution in mock, I again got confused…
Hi Anish,
Could you please summarize based on Kiakaha’s explaination what is what?..I would prefer list so that understanding it is easier….btw how was the mock and how much did you score? Do you mind sharing?
 
Kiakaha Wrote:
——————————————————-
> you are right, treasury rate is just ‘risk free
> rate’ – apart from TIPs, as you point out. All
> other treasuries are nominal rates ie include
> compensation for inflation.
>
> i couldn’t see those corrections in the errata
> either, any advice appreciated…
Thanks. That makes sense. But my question then is, if we want risk premium, shouldn’t it be just:
(1 + Risk Premium for equities) = (1 + Return on Equity)/(1 + Return on T Bill)
In the mock explanation, they calculate it as following:
(1+Risk Premium) = (1+Return on Equity)/(1+Return on T Bill) * (1+Inflation Rate)
i.e. they assume T Bill return to be ‘Real risk free rate’. Why?
 
sgupta0827 Wrote:
——————————————————-
>
> Hi Anish,
>
> Could you please summarize based on Kiakaha’s
> explaination what is what?..I would prefer list so
> that understanding it is easier….btw how was the
> mock and how much did you score? Do you mind
> sharing?
Don’t know what is what yet. Trying to understand. Let’s get this sorted out, then we can clearly re-state it.
My mock was fine. But I did terribly in Ethics (In the 2 sessions combined, I had 13 errors in Ethics ALONE and 13 in all other sections together!)… Anyway, I am reviewing Ethics again.
 
> Don’t know what is what yet. Trying to understand.
> Let’s get this sorted out, then we can clearly
> re-state it.
> My mock was fine. But I did terribly in Ethics (In
> the 2 sessions combined, I had 13 errors in Ethics
> ALONE and 13 in all other sections together!)…
> Anyway, I am reviewing Ethics again.
voww 13 in other section is definitely very good. I wish I had that kind of preparation and accuracy. Out of 18, 13 errors that’s way too much. What’s wrong man? I could get 50% just by common sense when I had not read the material at all. Probably, you are sweating too much for ethics. Be calm headed while reading those questions. Ethics is not that tough to make those many mistakes. Let me know if you need any help.
 
sgupta0827 Wrote:
——————————————————-
>
>
> voww 13 in other section is definitely very good.
> I wish I had that kind of preparation and
> accuracy. Out of 18, 13 errors that’s way too
> much. What’s wrong man? I could get 50% just by
> common sense when I had not read the material at
> all. Probably, you are sweating too much for
> ethics. Be calm headed while reading those
> questions. Ethics is not that tough to make those
> many mistakes. Let me know if you need any help.
:) It is actually 13 out of 36. I was talking about both morning n afternoon sessions combined. Nevertheless, it still is pretty bad, I know. I just don’t get the hang of what all is a part of each std. Focusing more now. Thanks for your offer to help. Will let you know if I am stuck.
And now, back to the question to everyone, any ideas on why T Bill return is taken as ‘REAL risk free rate’?
 
the only thing I can think of is that they meant the ‘real’ (in the question) to apply to both the things that came after it ie the rate of return AND the risk premium. otherwise it just doesn’t make sense to me.
 
Could it be that since it’s a short term rate, it does not reflect inflation?
 
Bumping this to see if someone can find that errata – it’s not on the CFA website. in the textbook they say that the nominal return consists of three parts: real risk free return; inflation compensation; and a risk premium.
This still doesn’t answer the question though because in the mock they gave you the t bill rate which would include real risk free rate, AND inflation compensation. Therefore, I don’t get the way they solved it, it looks like they have adjusted for inflation twice. (by using the inflation-adjusted figure in the numerator).
Has anyone written in to CFA about this?
 
Kiakaha Wrote:
——————————————————-
> Bumping this to see if someone can find that
> errata – it’s not on the CFA website. in the
> textbook they say that the nominal return consists
> of three parts: real risk free return; inflation
> compensation; and a risk premium.
>
> This still doesn’t answer the question though
> because in the mock they gave you the t bill rate
> which would include real risk free rate, AND
> inflation compensation. Therefore, I don’t get the
> way they solved it, it looks like they have
> adjusted for inflation twice. (by using the
> inflation-adjusted figure in the numerator).
>
> Has anyone written in to CFA about this?
I have mailed them. Am waiting for their reply.
 
cfa_bombay Wrote:
——————————————————-
> Anish
>
> Did you get a reply ?
Nope!
 
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