 # Risk Premium

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:

1. 1.5%.
2. 1.8%.
3. 2.1%.

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%