CFA Level I Mock Exam Afternoon Q117 someone, problem, solution, difference, understand

irlfaan7

I don't understand the solution why real risk premium is (B) 3.8%

The solution is (1+6.9%)/(1+3%) - 1 = 3.8%

When I do this problem, I just calculate the real equity return and real risk free return and the difference of the two rates is the risk premium.

r(e) = (1+9%)/(1+2%) = 6.9%
r(f) = (1+3%)/(1+2%) = 0.98%
risk premium = 6.9% - 0.98% = 5.88% which is (C)

Can someone give me some help here? Thanks

Daniel1985

I agree verbiage of the question is bit misleading but I don't think you are asked to calculate real risk premium here. It's "real rate of return for equities" and "risk premium for equities". Risk premium for equities is the extra risk you take to invest in equities because of uncertainty in future the cash flows. Your calculation would have been correct if you were asked to calculate real risk premium for equities. I hope it helps!

farrukhsadiq

I think there's an error there. Exactly same question is in practice problems for reading 52 of vol 4 curicullum (question 11-14, p.380). In curriculum calculation is correct.

So to calrify again:
Rnom - nominal rate of return
Rf- risk free rate
Rp- risk premium
Rinf - inflation rate

(1+Rnom)=(1+Rp)(1+Rf)(1+Rinf)
If you divide both sides by (1+Rinf) you get
(1+Rnom)/(1+Rinf)=(1+Rp)(1+Rf) =>is called real rate of return

Now coming back to mock - real rate of return for equities is:
1.09/1.02 =1.0686 which is ok

However in order to get Rp for equities you need to:
(1+Rnom)/[(1+Rf)(1+Rinf)] where (1+Rf)(1+Rinf) is equivalent to 3% (treasury bills for which Rp=0)
so (1.09)/(1.03) = 1.0582 => correct answer should be C

As I said, in curriculum they calculate it correctly, no idea why mistake here, hope they will make it correctly for real exam.

Edit: BTW they posted errata to this specific question on www with mocks. So we're both right and they have corrected it



Edited 1 time(s). Last edit at Wednesday, June 1, 2011 at 06:14PM by dadalsky.