Question

You’ve observed the following returns on Barnett Corporation’s stock over the past five years: –25.5 percent, 14 percent, 31 percent, 2.5 percent, and 21.5 percent. The average inflation rate over this period was 3.25 percent and the average T-bill rate over the period was 4.3 percent.

a. What was the average real return on the stock? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Average real return              %

b. What was the average nominal risk premium on the stock? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Average nominal risk premium              %

Answer 1

Solution :-

Average Nominal Rate = sum of nominal rates/ no. of rates

= ( -25.50% + 14% + 31% + 2.50% +21.50% ) / 5

= 8.70%

(A).

Using Fisher equation average real return can be found out by:

(1+ average nominal rate ) = (1+average real rate ) * (1+ average inflation rate)

= ( 1+0.087 ) =(1+ average real rate) * (1+ 0.0325)

= ( 1 + average real rate ) = (1.087) / (1.0325)

= Average real rate = 1.0528 - 1

= Average real rate = 0.05278

= 5.28% (two decimals)

(B)

Average nominal risk premium = average nominal rate - average risk free rate

here, average nominal rate is calculated as 8.70% above

average risk free rate is the average T bill rate i.e,4.30%

Average nominal risk premium = 8.70 % - 4.30 % = 4.40 %.

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