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  Tuesday November 21, 2017

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APPROXIMATIONS OF RISK PREMIUMS AND THE RISK-FREE RATE
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Because U.S. Government securities have virtually no default risk due to the government's ability to raise taxes or print money, these assets are referred to as risk-free. As such, their current rate of return is used as a proxy for the risk-free rate.

Investors face different types of risks. Equity risk, small stock risk, bond default risk, and bond horizon risk all have premiums that reward investors with larger average returns for taking such risks. Ibbotson Associates calculated total nominal returns compounded annually for various asset classes for a period of 75 years. Their results will give you a good idea of the average premium awarded for taking on risk.

? Treasury bills—3.8%

? Intermediate-term government bonds—5.3%

? Long-term government bonds—5.3%

? Long-term corporate bonds—5.8%

? Large-company stock returns—11.2%

? Small-company stock returns—12.4%

As you can see, the return for investing in large company stock returns has been much larger than the return provided by Treasury bills. In this case, the investor was rewarded for taking on equity risk. Similarly, the higher return provided by small stocks in relation to large stocks is a premium for taking on small stock risk.

Notice that the return on long-term corporate bonds was higher than the return provided by long-term government bonds. This is a premium for taking on bond default risk.

You can also see that the risk premium on bond horizon risk resulted in a higher return for intermediate and long-term government bonds compared to short-term Treasury bills.

In each of these cases, risk has been rewarded by higher returns. Of course, this data is a compilation of many assets over the course of 75 years. The future is never predictable, but these historical returns should give you a sense of how various risks are rewarded.




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