CFA Level I · CFA Level I Exam · Sources of Equity Returns
An analyst uses the Gordon growth model to estimate the equity risk premium. The forward dividend yield on the index is 2.5%, expected long-term dividend growth is 4.5%, and the risk-free rate is 3.0%. The estimated equity risk premium is closest to:
The equity risk premium is the expected market return minus the risk-free rate. Expected return is 2.5% yield plus 4.5% growth, or 7.0%. Subtracting the 3.0% risk-free rate gives a premium of about 4.0%.
- A1.5%
- B4.0%Correct
- C7.0%
Explanation
Expected market return = dividend yield + growth = 2.5% + 4.5% = 7.0%. Subtracting the risk-free rate gives 7.0% − 3.0% = 4.0%. The 7.0% option forgets to subtract the risk-free rate.
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