{"id":19112,"date":"2021-08-04T14:57:39","date_gmt":"2021-08-04T14:57:39","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=19112"},"modified":"2024-04-11T13:03:19","modified_gmt":"2024-04-11T13:03:19","slug":"explain-the-relationship-between-the-consumption-hedging-properties-of-equity-and-the-equity-risk-premium","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/explain-the-relationship-between-the-consumption-hedging-properties-of-equity-and-the-equity-risk-premium\/","title":{"rendered":"Equity and Equity Risk Premium"},"content":{"rendered":"\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/NFyA0qXHhww\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n<p>Equity refers to a security with an indefinite size and timing of dividends. Moreover, these dividends may stop in the event of bankruptcy. This makes equities riskier than debt. Equities, therefore, require an additional risk premium.<\/p>\r\n<p>More precisely, investors who invest in equities require a return given by:<\/p>\r\n<p>$$ \\left(R+\\theta_t+\\pi_t+\\gamma_t+k_t\\right) $$<\/p>\r\n<p>Where:<\/p>\r\n<ul>\r\n\t<li>\\(R\\) is the risk-free rate of interest.<\/li>\r\n\t<li>\\(\\theta_t\\) is the expected inflation.<\/li>\r\n\t<li>\\(\\pi_t\\) is the risk premium.<\/li>\r\n\t<li>\\(\\gamma_t\\) is the additional risk premium for credit risk (credit spread).<\/li>\r\n\t<li>\\(k_t\\) is the additional risk premium relative to risky debt for investment in the equities.<\/li>\r\n<\/ul>\r\n<p>The <strong>equity risk premium<\/strong> is the reward to investors over and above the compensation for risk required for holding a risk-free government bond. It is equal to \\((\\gamma_t+k_t)\\).<\/p>\r\n<p>The <strong>consumption hedging property<\/strong> highlights that the payoffs of securities during bad economic times matter more rather than their returns. In other words, assets that provide higher payoffs during economic downturns are highly valued because of the consumption hedging property. Thanks to this, such assets attract lower risk premiums.<\/p>\r\n<p>Equity provides a poor hedge against bad consumption outcomes. This is because when there is a recession, the value of equity declines. On the other hand, government bonds pay off substantially during bad economic times. A risk-averse investor would, therefore, demand a higher premium on an equity holding than a government bond holding. It is equity&#8217;s poor consumption hedging ability that informs such a preference.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>Which of the following statements about equity is the <em>least accurate<\/em>?<\/p>\r\n<ol type=\"A\">\r\n\t<li>Equity provides a poor hedge against bad consumption outcomes.<\/li>\r\n\t<li>Assets that provide a higher payoff during economic downturns have lower risk premiums.<\/li>\r\n\t<li>The consumption hedging property highlights that the payoff of a security during good economic times is what matters more than its return.<\/li>\r\n<\/ol>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is C.<\/strong><\/p>\r\n<p>The consumption hedging property highlights that the payoff of a security during <strong>bad<\/strong> economic times is what matters more than its return.<\/p>\r\n<p><strong>A is incorrect.<\/strong>\u00a0Equity provides a poor hedge against bad consumption outcomes. This is because when there is a recession, the value of equity declines.<\/p>\r\n<p><strong>B is incorrect.<\/strong>\u00a0Assets that provide a higher payoff during economic downturns are highly valued because of the consumption hedging property. As such, the risk premiums on the asset are lower.<\/p>\r\n<\/blockquote>\r\n<p>Reading 43: Economics and Investment Markets<\/p>\r\n<p><em>LOS 43 (i) Explain the relationship between the consumption-hedging properties of equity and the equity risk premium.<\/em><\/p>\r\n","protected":false},"excerpt":{"rendered":"<p>Equity refers to a security with an indefinite size and timing of dividends. Moreover, these dividends may stop in the event of bankruptcy. This makes equities riskier than debt. Equities, therefore, require an additional risk premium. More precisely, investors who&#8230;<\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,473],"tags":[216,564],"class_list":["post-19112","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-portfolio-management","tag-cfa-level-2","tag-portfolio-management","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Equity and Equity Risk Premium - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"The equity risk premium is the reward to investors over and above the compensation for risk required for holding a risk-free government bond.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/explain-the-relationship-between-the-consumption-hedging-properties-of-equity-and-the-equity-risk-premium\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Equity and Equity Risk Premium - 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