a. Suppose that over the long run, the risk premium on stocks relative to Treasu

Question

            a. Suppose that over the long run, the risk premium on stocks relative to Treasury bills has been 7.6% in the United States. Suppose also that the current Treasury bill yield is 1.5%, but the historical average return on Treasury bills is 4.1%. Estimate the expected return on stocks and explain how and why you arrived at your answer.

            b. Suppose that over the long run, the risk-premium on stocks relative to Treasury bonds has been 6.5%. The current Treasury bond yield is 4.5%, but the historical return on T-bonds is 5.2%. Estimate the expected return on stocks and explain how and why you arrived at the answer.

c.      Compare your answers above the explain any differences.

Explanation / Answer

a. market risk premium = expected market returns - risk free rate

risk free rate = historical average return on T bills = 4.1%
We do not take the current T bill yield as risk free rate as it can be influenced by current market conditions.

thus expected market returns = market risk premium + risk free rate = 7.6% + 4.1% = 11.7%

b.risk free rate = historical average return on T bills = 5.2%
market returns = market risk premium + risk free rate = 6.5% + 5.2% = 11.7%

c. The answer in both the case is 11.7%. In the second case though, the risk free rate is higher. That is we can get a higher return from T-bills itself, and taking higher risks by investing in the markets isnt as rewarding as in the first case.

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