Question

Average Annual Rates Standard Deviation
T-Bills Inflation Real T-Bill T-Bills Inflation Real T-Bill
All months 3.46 2.35 0.56 3.12 4.07 3.81
First half 1.04 1.68 − 0.29 1.29 5.95 6.27
Recent half 4.45 3.53 0.90 3.11 2.89 2.13
(1926-2016) Market Index Big Growth Big Value Small Growth Small Value
Mean excess return (annualized) 0.83 7.98 11.67 8.79 15.56
Standard deviation (annualized) 18.64 18.50 24.62 26.21 28.36
Required:
1. Suppose that the inflation rate is expected to be 2.35% in the near future using the data provided above, what would be your predictions for the following? (Round your answers to 2 decimal places.).
a. The T-bill rate? _________%
b. The expected rate of return on the Big/Value portfolio? __________%
c. The risk premium on th stock market?

Answer 1

Answer:

1. 2.92%

2. 14.59%

3. The risk premium on the stock market does not change.

Explanation:

1. The T-bill rate:  real rate + inflation = 0.56% real rate + 2.36 % inflation = 2.92%

The T-bill rate is 2.92%

2. Expected return on Big/Value: T-bill rate +  historical risk premium

Expected return on Big/Value: 2.92% T-bill rate + 11.67% historical risk premium = 14.59%

The expected rate of return on the Big/Value portfolio is 14.59%

3. A risk premium is a return on investment above the risk-free rate that an investor needs to be compensated for investing in higher-risk investments. Since the systematic risk i.e the market risk, is expected to remain the same, the risk premium on the stock market is also not expected to experience any change.