Discuss how changes in economic conditions are likely to affect the equity-risk premium and stock prices. Considering the risks associated with investing in stocks (over short periods of time), what types of investments would you expect investors to buy during an economic recession?

Question

What will be an ideal response?

Answer 1

If investors expect a recession, it is likely this will lead to an increase in the equity-risk premium. The potential losses associated with stocks are greater during economic downturns, so investors will have a higher required return on stock. All other things equal, this will lead to a decrease in stock prices. During an economic recession, U.S. Treasury securities are relatively more attractive than stocks, so we would expect that investors would purchase more of them relative to equity shares. Recall that stockholders are residual claimants. With bankruptcy more likely during a recession, the expected losses associated with being a residual claimant are higher.