Question

You read in BusinessWeek that a panel of economists has estimated that the long-run real growth rate of the U.S. economy over the next five-year period will average 7 percent. In addition, a bank newsletter estimates that the average annual rate of inflation during this five-year period will be about 6 percent. What nominal rate of return would you expect on U.S. government T-bills during this period? Round your answer to two decimal places.

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What would your required rate of return be on common stocks if you wanted a 4 percent risk premium to own common stocks? Do not round intemediate calculations. Round your answer to two decimal places.

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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?

As an investor becomes more risk averse, the required rate of return will increase or decline and the stock prices will increase or decline

Answer 1

Nominal interest rate= R(1+i)+i

Where R= Real interest rate (given as 7%) and i= inflation rate (given as 6%)

Plugging the values, Nominal rate expected on Treasury bills= 7%(1+6%)+6% = 13.42%

Given, risk premium required on stock= 4%

Required return on common stock= Risk Free rate (Treasury bill rate as above) + Risk premium

=13.42% + 4% = 17.42%

As an investor becomes more risk averse, the required rate of return will increase and the stock prices will decrease.