EOC q11 Reading 30 Return Concepts (Equity)

[300hoursoverand]

Can some one tell me how they estimated the historical ERP which is given in the solution as 2%.
I understood the supply side calculation for ERP.

 

[Harrogath]

Line 7
“The geometric mean return relative to 10-year goverment bond returns over 10 years is 2 percent per year”
There you got that ERP is 2%
In question 10 you got that Ibbotson-Chen model gives a ERP of 4.3%
Also you have the current short-term and long-term goverment bond yields (9% and 7% respectively)
Therefore, using CAPM, your required return can be:
7% + 1 x 2% = 9%
or
9% + 1 x 2% = 11%
or
7% + 1 x 4.3% = 11.3%
or
9% + 1 x 4.3% = 13.3%
All required returns, using different calculations available, are at least 9%. Then C is correct

 

[300hoursoverand]

Harrogath wrote:
Line 7
“The geometric mean return relative to 10-year goverment bond returns over 10 years is 2 percent per year”

Does this mean that return is 2% above the government bond yield?
So 2% is the ERP based on Bond yield-risk premium approach?

 

[Harrogath]

Exactly.
You may be confused because the word “relative”. The sentence tells you that equity returns (geometric mean) over 10 years are above the 10-year goverment bond yield by 2%, so it is:
ERP = E(rm) - RF
ERP = 2%
Gain and save experience with this kind of “wordings”.
Regards.