Capm

Mgmt 232a: Problem Set 1 Bonds vs Stocks ∗

Hanno Lustig TA: Matthias Fleckenstein April 2, 2011

Bonds vs Stocks: It is December 31, 2010. You have to advise the endowment management company of Stanford University (Stanford Management Company) on its overall asset allocation decision between bonds and equities. The endowment management company is conducting its 10year review. A key part of this review is to come up with an assessment of the likely performance of the stock market. The spreadsheet includes cum dividend and ex dividend value weighted returns on the NYSE-AMEX-NASDAQ provided by CRSP, as well as nominal and real long-term bond yields. 1. Please use the data provided in the spreadsheet to come up with an estimate for the equity premium at the end of 2010 by comparing the stock yield to the bond yield. Base your recommendation on the forward looking equity premium estimate. Carefully state your assumptions. (a) Let R denote the cum dividend return, and let Rx denote the ex dividend return. To estimate the dividend yield (D/P )t , you can use this identity : (D/P )t+1 = Rt+1 /Rxt+1 − 1 = (Pt+1 + Dt+1 )/Pt − 1. Pt+1 /Pt

(b) To back out dividend growth rates, use the following identity: Dt+1 /Dt =

∗

(D/P )t+1 Rxt+1 . (D/P )t

You can work in groups of up to 4 students, and you can just hand in one set of solutions that has all the names of the contributing students on it. The problem set is due on April 11 by 8.00 AM. Use the electronic drop box to submit your answers. Submit the Excel file and the file with a short write-up of your answers.

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2. Compute a real stock yield, using a real dividend growth estimate and the same dividend yield. Compare this to the TIPS yields to get a second equity premium estimate. Does this new estimate cause you to substantially modify your recommendation? 3. You also need to convince the board that this estimate of the equity premium as part of the 10-year review is useful. You can do so by comparing previous...