If ‘the markets are overvalued’, why would that lead to a lower equity risk premium? I would think the risk premium would be higher if the markets were overvalued?
I came across this in a problem- we are asked to update certain economic parameters for a hypothetical firm due to a recent economic slowdown. Wouldn’t we want a higher equity risk premium and therefore higher required return and lower prices in our models?
The Ibotsen chen formula though shows a negative impact from the p/e piece of the formula though…again the question gave us that the markets were overvalued 3% so that factor in the formula becomes
when the economy slows - what does the government do? Try to keep the interest rates as low as possible. So essentially the risk free rate drops. So (Return on Equity - Risk Free Return) INCREASES - so the Equity Risk Premium increases.
Once the required return goes up - the prices drop (due to the inverse relationship among those terms).
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Market is overvalued - so Prices are HIGHER - which means Required return is lower - and given Required return = rf + beta * (return on market - risk free rate) -> it means (rm - rf) term is becoming SMALLER - so the equity risk premium is going smaller…