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You read in The Wall Street Journal that 30-day T-bills currently are yielding 6 percent. Your friend, a broker at Buffett Securities, has given you the following estimates of current interest rate premiums:

a. Inflation premium 2%
b. Liquidity premium 1%
c. Maturity risk premium 1%
d. Default risk premium 3%
What is the real risk-free rate of return (r*) based on the provided data?

User Anton Tupy
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1 Answer

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Final answer:

To calculate the real risk-free rate of return (r*), we subtract the given premiums (inflation, liquidity, maturity risk, and default risk) from the nominal yield of 6% from T-bills. Typically, T-bills do not have a default risk premium, which would lead to a corrected real risk-free rate of return of 2% rather than the initially calculated -1%.

Step-by-step explanation:

To find the real risk-free rate of return (r*), we can use the given yields and premiums from the 30-day T-bills as reported in The Wall Street Journal. The nominal yield of the T-bills is 6 percent, which includes various premiums reflecting different risks and inflation expectations.

According to the information provided, we have an inflation premium of 2%, a liquidity premium of 1%, a maturity risk premium of 1%, and a default risk premium of 3%. To determine the real risk-free rate of return, we subtract these premiums from the nominal yield.

The calculation is as follows:

Nominal yield on T-bills: 6%

Inflation premium: -2%

Liquidity premium: -1%

Maturity risk premium: -1%

Default risk premium: -3%

Thus, the real risk-free rate of return (r*) is:

6% - (2% + 1% + 1% + 3%) = -1%

However, this calculation suggests a negative real risk-free rate of return, which is unusual. This could be due to an error in the information provided or an anomalous financial market condition.

Typically, the default risk premium would not apply to T-bills since they are considered free of default risk, being backed by the full faith and credit of the U.S. government. Without considering the default risk premium, the real risk-free rate of return would be:

6% - (2% + 1% + 1%) = 2%

User Timur Osadchiy
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