# 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 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%