Ibbotson-Chen

[Snah]

Hi All,

I am getting confused when I am asked to answer this type of questions. They use to overwhelm you given a lot of different rates and I always put at least one wrong.
A good example of this is the esercise 10 in the reading 30 in the CFA curriculum.

Could you give me some advice to solve this problems properly?

Thanks

S

 

[krokodilizm]

Apparently this is not in the Schweser material and most people claim it is not part of the curriculum either. I just saw the formula for the first time and I think I know why Schweser skipped it altogether…

 

[Snah]

Is in the Schweser notes, Page 18; equity book. But my problem resides in the amount of different rates given in the vigette… I always get it wrong!

 

[thalesian]

Ibbotsen-Chen is easy to remember when you break the componets down into parts. It is also a forward-looking model, so all components should be expected returns.
(1) The first major division is between the nominal return minus risk-free free rate.
For the risk-free rate, we use the expected return on the 10-year note.
(2) The nominal return also breaks into two parts – the returns from capital appreciation and returns from dividends.
For dividends, we used the forward dividend yield.
(3) The returns from captial appreciation have three components – expected inflation, expected growth rate in real earnings and expected multiplier expansion (“expected growth rate in the P/E ratio”).
These are simply multiplied together to get the expected capital gain.
You end up with roughly:
(E[Inflation] * E[Real Earnings Growth] * E[Multiplier Expansion]) + E[Dividend Yield] - E[Risk-Free Rate]
Don’t be fooled if they give you a GDP growth rate (the growth rate for the economy) and a real earnings growth rate (the earnings growth rate for private companies). While they should track each other, they are not the same.