Question #10

The additional risk-premium for real estate is due to lack of liquidity. (Module 39.2, LOS 39.k) Most economic observers in the Republic of Nearland agree that the country will suffer a recession in the near future. At an economics conference at Nearland's premier university, four professors were having a lively discussion about how economic theory, the business cycle, and investment performance interact. Professor Adams made two statements about the utility of consumption being an important driver of interest rates: Statement 1: "If we believe that a recession is likely in the future, we would expect the marginal utility of consumption in the future to be lower relative to the utility of current consumption, and the inter-temporal rate of substitution to be higher than they would otherwise be if there was optimism about future economic conditions." Statement 2: "It is my estimate that consumption in one year's time has 5% less utility than consumption in the present." Professor Brady poured scorn on Professor Adams' second statement. He replied that predicting such precise values for abstract economic concepts such as utility was impossible. Trying to value bonds and interest rates, he argued, was much more likely to be accurate if calculations were based on more measurable macroeconomic fundamentals, such as GDP growth and inflation. Central bank policy rates, he stated, are positively correlated to current inflation and current GDP growth. Professor Chapman attempted to mediate between Adams and Brady. He said, "In a way, you both have a point. At the top of the business cycle there is higher inflation and current GDP growth. At the same time, market participants begin to worry about future recession, which increases the marginal utility of delayed consumption. These conditions both explain a steepening of the upward-sloping yield curve." Professor Douglas tried to move the conversation towards the business cycle and risk premiums. She presented the audience with economic data as presented in Exhibit 1, and challenged observers to calculate the equity risk premium in Nearland. Exhibit 1: Economic Data for Nearland Break-even rate of inflation 2.80% Credit spread 3.10% Risk premium for equities relative to debt 4.50% Professor Douglas went on to discuss asset classes, which could act as a consumption hedge to guard against the upcoming recession. She invited the audience to attend her upcoming discussion seminar where she would analyze the prospects for real estate, growth stocks, and value stocks.