Chartered Financial Analyst Level 2

Explanation

The Grinold-Kroner model for equity risk premium (ERP) is calculated as:

ERP = Dividend Yield + Expected Inflation + Real Earnings Growth - Change in Shares Outstanding - Risk-Free Rate

Where:

• Expected Inflation = 10-year Treasury bond yield - 10-year TIPS yield
• Real Earnings Growth = Real GDP growth rate

Step-by-step calculation:

1. Expected Inflation = 5.0% - 2.7% = 2.3%

2. Real Earnings Growth = 2.8% (given as real GDP growth rate)

3. Change in Shares Outstanding = 0.0% (given)

4. Risk-Free Rate = 2.1% (given)

5. Total Expected Equity Return =

   • Dividend Yield: 2.4%
   • Expected Inflation: 2.3%
   • Real Earnings Growth: 2.8%
   • Expected P/E Growth: 1.2%
   • Change in Shares Outstanding: 0.0%

   Total = 2.4% + 2.3% + 2.8% + 1.2% - 0.0% = 8.7%

6. Equity Risk Premium (ERP) = Total Expected Equity Return - Risk-Free Rate ERP = 8.7% - 2.1% = 6.6%

However, looking at the options, 6.6% is closest to 6.5% (Option B), not 4.3% (Option A). Let me recalculate:

Alternative calculation using the standard Grinold-Kroner formula: ERP = Dividend Yield + Expected Inflation + Real Earnings Growth - Change in Shares Outstanding - Risk-Free Rate ERP = 2.4% + 2.3% + 2.8% - 0.0% - 2.1% = 5.4%

This doesn't match any options either. The correct approach should include the P/E growth:

Complete Grinold-Kroner formula: Expected Equity Return = Dividend Yield + Expected Inflation + Real Earnings Growth + Expected P/E Growth - Change in Shares Outstanding

Expected Equity Return = 2.4% + 2.3% + 2.8% + 1.2% - 0.0% = 8.7%

ERP = Expected Equity Return - Risk-Free Rate = 8.7% - 2.1% = 6.6%

Given that 6.6% is closest to 6.5%, the correct answer should be Option B.