Use the (fictional) information given below to answer the questions that follow.

Question

Use the (fictional) information given below to answer the questions that follow. Yield investors require on a Hilton Hotels 2015 bond: 8% Risk-free rate measured by the 3-month Treasury bill: 3% Expected inflation rate: 1% a. Find the real rate of return on the 3-month Treasury bill, and explain what that means. (Restating the formula is not an explanation). b. Find the risk premium on the Hilton Hotels bond, and explain what a risk premium represents. What is the purpose to the investor of receiving the risk premium? (Restating the formula is not an explanation.)

Explanation / Answer

a. real rate of return on the 3-month Treasury bill = risk free rate - inflation rate = 3%-1% = 2% b. risk premium on the Hilton Hotels bond = 8% - 3% = 5% Risk premium is the return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is a form of compensation for investors who tolerate the extra risk - compared to that of a risk-free asset - in a given investment.

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