You expect the inflation rate to be 5.2% and the U.S. Treasury bill yield to be 6.5% for the next...

Question:

You expect the inflation rate to be 5.2% and the U.S. Treasury bill yield to be 6.5% for the next year. You also expect the risk premium on small-company stocks to be 3.2% for the year.

What rate of return do you expect to earn on small-company stocks over the next year?

A. 3.3%

B. 8.4%

C. 9.7%

D. 11.7%

E. 14.9%

The risk premium of a risky asset is the expected return on the asset in excess of the risk free rate. Thus, the risk premium indicates the amount of returns earned because of risk-bearing. In the capital asset pricing model, an asset's risk premium is the product of its beta and the market risk premium.

The answer is C.

The risk premium is by definition calculated as follows:

• risk premium = expected return - risk free rate

The US Treasury bill yield is usually used as an approximate the risk free rate, which is 6.5%. We also know that the risk premium is 3.2%, thus we have:

• 3.2% = expected return on small-company stocks - 6.5%
• expected return on small-company stocks = 9.7% 