Question

If, as a result of the disruption caused by the Covid-19 pandemic, the share market return in 2020 turns out to be –25%, explain what will happen to our estimate of the "normal" risk premium and discuss whether this makes sense.

Answer 1

As a result of disruption which has been caused due to covid-19, The share market all across the world has slipped into a bear territory due to uncertainty caused by the covid-19 pandemic and it is expected to continue this way only because of expectation of an impending recession in the entire Global world and the shrinkage of demand which can entirely visible through lack of global growth in the global economy so it can be said that there is a lot of uncertainty and possibility of making a higher rate of return in the stock market is very low.

In such times, when there is a lower probability of making higher rate of return in the stock market, the risk premium will be going up because the investors who are wanting to invest into the equity markets will be demanding a higher risk premium as there is higher risk associated with the overall capital erosion of their capital so they would be trying to to demand higher rate of risk premium and it will be reflected through a larger derivation of risk premium from the historical mean because this is not a normal situation and among such uncertainty the equity investors will be trying to demand an excess risk premium due to uncertainty in the market.