Equity Vs. Bonds: The Liquidity Trap in The Uk

...

Nevertheless, the research of Westaway and Thomas (2013) demonstrates that investment in government bonds with low yield are still good strategy in risk reduction perspective that fixed income securities play in portfolio. Nowadays’ yield environment provides that investors are not able use as the historical return during the past 30 years, but if the investors assume as individual investment into bonds and hold it till maturity it is good factor of future performance. Despite of this, the key determinant of owning gilts on the today’s yield is that concerning about only on returns investors forget very vital dimension in making portfolio mix which is risk.

2.2 Empirical approach of Equity Risk Premium

The term of Equity Premium Puzzle was introduced in 1985 by Prescott and Mehra, it appears to absence of consensus between economists and financial experts on why demand for government bonds is high with less returns rather than equity. It can be explained as changes to the expected preferences of investors and limitations in the risk aversion model (Mehra and Prescott, 1985). The equity risk premium is calculated by which return of asset exceeds the risk free rate. Dimson et al. (2008) found that the ERP is about 3.5% for global market in 1900-2005, but if it considered over one decade, it shows high volatility from more than 19% in the 50s and 0.3% in the 70s.

Many researches have evidenced the great relationship between recessions and the equity risk premium. Meanwhile, various studies have appeared in the literature, most of them are concentrated on the United States and there are just a few on the position of asset market in the UK after the financial crisis 2008.

Barro at el (2009) noted that the evaluation of assets in 24 countries for 100 years had impact of crisis on equity risk premium. They determined that effects on the equity risk premium are contingent on utility functions where investors usually are more risk aversion to avoid uncertainty with interest rate and inflation. Consequently, the study concluded high risk premiums were normal for the most of economic recessions.

Moreover, the study of Arouri and Jawadi (2010) analyzed the equity risk premium in the United States throughout all economic crises. They estimated that the increase in the equity risk premium had been observed in most of recessions; especially they admitted that the significant increase in volatility of prices and the systematical risk in the US were in the financial crisis 2008.

Long term fixed income securities are able to gain capital profits when interest rates drop while short term bonds are the suitable choice when rates are increasing. The research of Aydogan at el (2012) identified that long term government bonds provided great returns in Equity Premium Risk that included a full business cycle. The intention of high returns is associated with low volatility rather risk of short term bonds yields. Moreover, Millar (2013) estimated that bonds outperformed equity returns after 2009 to 2011 in the UK by explaining that in terms of quantative easing and the relationship between depreciation of yields and appreciation of prices. However, Hammond and Lebowitz (2011) stated that when yields are inhibited in low interest rate environment by balancing of price appreciation and providing high return in total, the equity risk premium should be considered in long time period.

Inflation plays significant role in determination of bond yield as it depreciate the purchasing power of free risk asset’s future cash flow. Empirical study by Damodaran (2012) was concerned about the correlation of the equity risk premium with macroeconomic indicators using S&P500 and US Treasure Bonds for 1973-2011. He identified that inflation has only correlation with the equity risk premium as the inflation rise – the equity risk premium will be greater. However, Brandt and Wang (2003) stated that inflation is determined only when risk aversion concept implements.

3. Data and Methodology

In order to examine the Equity Risk Premium to show what kind of asset outperforms other, the required UK data has been gathered from various web-data application such as Thomson One, Yahoo Finance, Bank of England and UK Debt Management Office.

Calculations of this study are concentrated on the FTSE100 as equity and UK conventional gilts with inflation, dividends and capital adjusted. According to FTSE website (2014), they describes the FTSE100 as index that shows the performance of the most strongest companies listed on the London Stock Exchange and it takes 98 percentage of UK capital market. Therefore, FTSE100 is appropriate measure of the whole equity market of the UK. The analysis will be considered from the financial crisis 2008 till 2014 in monthly frequency.

Dimson et al (2002) stated that it is important to apply total returns which take into account dividends compromising the equity return. The suitable way to estimate that, earing yield should be used. However, estimation of the earning yield is more complicated for this paper, since FTSE100 does not have shares as it is just index that summarise all shares in many companies. In order calculate expected return of equity, this study implemented calculation of return based on adjusted prices that include all stocks’ dividends and cash dividends by formula:

[pic 2]

As long as this assignment implements historical equity premium risk approach that considers free risk rate with free probability of default risk. The best measure of free risk rate is 10 year UK Treasury Gilts, this kind of bond has no default risk and semi-annually interest payments. This coupon bond identifies our problem statement by changing yield for investors as UK interest rate has been decreased to 0.5% from the financial crisis 2008. However, it is a key aspect of the ERP on what exactly it has been evaluated against, that why 3 month UK Treasury Gilts will be considered as different measure of risk-free rate and compared to first one. The collected historical rates of return are included capital element. Dimson et al (2002) conducted that expected return for bonds is usually disappointed for investors that experiencing capital losses. Moreover, they stated that to gain a clear evaluation of equity premium risk, it is appropriate to use long term examination.

Therefore, Equity Risk Premium can be defined as total expected return on equity minus the risk-free rate.

[pic 3]

Where, ERPt is the calculated the equity risk premium in time t, Re is the comprehended return on the