Question

Question 3: Equity Premium and International Income Covariances i Provide an expression for an individual investor's required return on equity. What does it depend on? How can we explain the equity premium based on this relation? ii) Suppose a German investor is considering whether to buy US stocks. Ignore exchange rate considerations. Suppose their labor income tends to comove with German GDP (gross domestic product), that is, when German GDP is high, their income will be high as well. Assume that German GDP is negatively correlated with US GDP, that is, when German GDP is low, US GDP is high. How will the German investor's required return on US stocks compare to that of a typical American investor? Explain you answer. MacBook Air FVO F9 F8 F7 F4 F5

Answer 1

i) ke = Rf+Beta*(Rm-Rf)

The expected return depends upon, the risk-free rate and the firm-specific risk premium

ii) Suppose that German GDP is high implies US GDP is low.

Thus, the income of labor in German is high and in the US it is low.

However irrespective of the level of income, the expectations would be high for both German and American Investor