Question

You’ve observed the following returns on Crash-n-Burn Computer’s stock over the past five years: 6 percent, -14 percent, 24 percent, 14 percent, and 17 percent. The average inflation rate over this period was 3.2 percent and the average T-bill rate was 5.25 percent.

  

Requirement 1:

What was the average real return on Crash-n-Burn’s stock? (Do not round intermediate calculations.)

(Click to select)6.01%6.61%12.90%6.31%5.71%

   

Requirement 2:

What was the average nominal risk premium on Crash-n-Burn’s stock? (Do not round intermediate calculations.)

(Click to select)0.60%4.15%3.78%3.36%2.95%

Answer 1

Requirement 1

Nominal returns are

R₁=6%, R₂= -14.00%, R₃= 24%, R₄=14%, R₅=17%

Average nominal return over the period = (Sum of returns of five years) / No of years = (R₁ + R₂ + R₃ + R₄ + R₅) / 5

Average nominal return over 5 years = R_N = [6% + (-14%) + 24% + 14% + 17%] / 5 = [6% -14% + 24% + 14% + 17%] / 5 = 47% / 5 = 9.40%

Average Inflation over 5 years = i = 3.2%

Average real return over 5 years = (1 + R_N) / (1 + i) - 1 = (1 + 9.40%) / (1 + 3.2%) - 1 = (1.0940 / 1.032) - 1 = 1.060077 -1 = 0.060077 = 6.0077% = 6.01% (rounded to two decimal places)

Hence Average real return on Crash n Burns Stock = 6.01%

Answer : 6.01%

Requirement 2

Average T bill rate = Average risk free rate = 5.25%

Average nominal risk premium over 5 years = Average nominal return - Average risk free rate = 9.40% - 5.25% = 4.15%

Hence Average nominal risk premium on Crash & Burn's Stock = 4.15%

Answer: 4.15%