Dear friends,

In topic portfolio management reading 43, we learn (1+ nominal return) = (1+risk free rate)*(1+inflation rate)*(1+risk premium). Given this I reason that (1+risk premium) = (1+ nominal return) / [(1+risk free rate)*(1+inflation rate)]

However, reading 43, question 13, which asks for the risk premium of equities given the below table , seems to go against my reasoning –

Asset Class

Geometric Mean %

Equities

8.0

Corporate Bonds

6.5

Treasury

2.5

Inflation

2.1

The risk premium is calculated as (1+0.08) / (1+0.025), however, I think given the aforementioned formula the answer should be (1+0.08) / [(1+0.025)*(1.021)]. Can someone please tell me what I’m missing? I’ve spent to long pondering this question, it has become my evil nemesis that must somehow must be tamed, ha… Please help

Your formula omits one important word:

(1 + nominal return) = (1 + real risk-free rate) × (1 + inflation rate) × (1 + risk premium)

If you’re given a nominal risk-free rate – as, for example, a Treasury rate – then you don’t add inflation because the nominal risk-free rate already incorporates the inflation premium.

Argh, I see now… Thanks so much S2000Magician, your reply is more than appreciated, you rock!!!

Good to hear.

You’re quite welcome.