Youve observed the following returns on Barnett Corporations

You’ve observed the following returns on Barnett Corporation’s stock over the past five years: –24.3 percent, 13.2 percent, 29.4 percent, 2.1 percent, and 21.1 percent. The average inflation rate over this period was 3.21 percent and the average T-bill rate over the period was 4.3 percent.

What was the average real risk-free rate over this time period? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Average real risk-free rate             %

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

Average real risk premium            

Solution

Question 1

Based on Fischer Equation,

(1 + Nominal Rate of Return) = (1 + Real Rate of Return) * (1 + Inflation)

(1 + 4.3%) = (1 + Real rate of Return) * (1 + 3.21%)

(1 + Real rate of Return) = (1.043)/(1.0321) = 1.0106

Real rate of return = 1.06%

{Note - Some texts mention simplified form of Fischer relation, which is Nominal rate = Real Rate + Inflation, which yields an approximate result. Here, the result would have been Real rate = 4.3% - 3.21% = 1.09%}

Question 2

Arithmatic Average Return for Stock = (-24.3% + 13.2% + 29.4% + 2.1% + 21.1%)/5 = 8.30%

Applying the Fischer relation,

(1 + 8.30%) = (1 + real rate)*(1 + 3.21%)

(1 + Real rate) = 1.0493

Real rate = 4.93%

Real Rsik Premium = Real rate of return on Stock - Real return Tbill = 4.93% - 1.06% = 3.87% --> Answer