Question

You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.5%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums:
Inflation premium = 3.25%

Liquidity premium = 0.6%

Maturity risk premium = 1.8%

Default risk premium = 2.15%

On the basis of these data, what is the real risk-free rate of return?

Answer 1

Answer:

Risk Free Rate of Return = 2.25%

Explanation:

The real risk-free rate is the difference between yield of the Treasury Bill and Inflation rate (matching investment duration).

Risk Free Rate of Return = T-Bill Yield - Inflation Rate

                                         = 5.5% - 3.25%

                                         = 2.25%

The risk-free rate is the minimum rate of return an investor would expect from any investment because he will not accept any sort of additional risk unless the potential rate of return is greater than the aforementioned risk-free rate.