An analyst observes the following historic geometric returns:
Asset Class** Geometric Return (%)** Equities 8.0 Corporate Bonds 6.5 Treasury bills 2.5 Inflation 2.1
The risk premium for corporate bonds is closest to:
Solution:
(1 + 0.043)/(1 + 0.0250) – 1 = 1.8%
Can anyone help me with this calculation?
No idea.
Where did you get this question?
They should be comparing 6.5% to 2.5%.
I managed to figured it out, risk premium is the extra risk that we are assuming than the risk free rate so,
(1+instrument - inflation rate) / (1+ risk free rate) -1
for the above question
(1 + (6.5 - 2.1)) / (1 + 2.5) - 1
= 1.0440 / 1.0250 - 1
= 1.018537 - 1
= 0.018537 * 100%
= 1.8537%
Comparing a real return (4.4%) to a nominal return (2.5%) doesn’t make a lot of sense.
Again: where did you get this question?
I got this Question in the CFA institute practice problems portfolio management.
In the 2019 syllabus , this is the working:
(1 + corporate bond nominal return) = (1 + T-bill return)(1 + inflation rate)(1 + risk premium)
1.065 = (1.025)(1.021)(1 + RP)
RP = 1.065/(1.025 x 1.021) - 1 = 1.77%
The workings is wrong as the T-bill return of 2.5% is a nominal return but it is treated as a real return here.
In the 2020 syllabus , they have amended the answer choices and also the workings:
(1 + corporate bond nominal return) = (1 + T-bill return)(1 + risk premium)
1.065 = 1.025(1 + RP)
RP = 1.065/1.025 - 1 = 3.90%