1. (Interest Rate Fundamentals) You read in Businessweek that a panel of economists has estimated that the long-run real growth rate of US economy over the next five-year period will average 3 percent. In addition, a bank newsletter estimates that the average annual rate of inflation during the five-year period will be about 4 percent.
What nominal rate of return would you expect on US government T-bills during this period.?
2. (Interest Rate Fundamentals) What would your required rate of return be on common stocks if you wanted a 5 percent risk premium to own common stocks given what you know from problem #1? If common stock investors became more risk averse,
What would happen to the required rate of return on common stocks?
What would be the impact on stock prices?
1. Require rate of return (RRR) = RP – E(R) – NRFR
Where, PR = risk premium of a given asset
NRFR = nominal return on risk free asset
E(R) = Expected return on an asset
5% = E(R) – 7.12%
= 7.12% + 5% = 12.12%
1. The required rate of return on the common stock is 12.12%
2. Return on common stock = (1 + .0712) (1 + .05) – 1 = 1.1248 – 1 = .1248 or 12.48%
(An approximation would be .03 + .04 + .05 = .12 or 12%.)
As an investor becomes more risk averse, the investor will require a larger risk premium to own common stock. As risk premium increases, so too will required rate of return. In order to achieve the higher rate of return, stock prices should decline.