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CFA Level I · CFA Level I Exam · Sources of Equity Returns

An analyst uses the historical-estimate approach for the equity risk premium. Over a long sample, the arithmetic mean annual return on equities was 10.0% and on government bills 3.0%. The geometric mean returns were 8.0% and 2.8%, respectively. Equity returns have a standard deviation of 18%. The analyst wants the premium most commonly used as a single-period expected premium estimate in the CAPM, and the equity risk premium is closest to:

The premium is about 7.0%. A single-period expected premium is best estimated from arithmetic means, so subtract the 3.0% bill return from the 10.0% equity return. The geometric difference of 5.2% reflects compound growth, not the one-period expectation.

  1. A5.2%
  2. B7.0%Correct
  3. C10.0%

Explanation

For a one-period forward-looking estimate, the arithmetic mean difference is used: 10.0% − 3.0% = 7.0%. The geometric difference is 8.0 − 2.8 = 5.2%, which suits multi-period compounding. 10.0% ignores the risk-free rate.

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