Reading 16 -- EOC question 3

Hi Everyone,

For question 3 part B. In calculating the total risk premium of the three securities the answer is given as:

[0+(1.0%+0.8%+0.9%)+0.95%]/3 = 1.22% - 1% = 0.22%.

Why is 1% subtracted from the 1.22%? I’m sure it’s probably something obvious that I overlooked but the answer is not coming to me.


1 is the principal component and you are only calculating the returns on principal. Think it this way - you started with 1 and ended with 1.22. So, your returns is 1.22 - 1 = 0.22

thanks - didn’t think there was a principal component factored into risk premium in this case.

The -1 is not a principal component factor. The question is trying to determine if the investor should invest or not. The investor has stated that he will invest if the spread ABOVE the 10 year treasury bond is at last .5% (50bps).

The total risk premium on this investment is 1.22. Now, test if it’s enough return. The spread of the 10 year treasury bond is 1% so you take 1.22% - 1% ( the given rate in this problem) = .22. .22 is less than the investor’s required .50 amount so the investor WILL NOT INVEST. Not enough required return.


Bravo. Thanks for the clarification.