An investor anticipates that inflation will be 4 per cent over the next year, and expects a return of 3 per cent for the pure time value of money. What risk premium will compensate the investor?
A) 1%
B) 12%
C) 7.1%
D) 7%

Question

Quizplus · Accepted Answer

The total required return for the investor is 7% (4% inflation + 3% pure time value). Therefore, the investor would require a 7.1% risk premium to compensate for the additional risk. This is calculated as follows:

Total Required Return = Inflation + Pure Time Value + Risk Premium
7% = 4% + 3% + Risk Premium
Risk Premium = 7% - 4% - 3%
Risk Premium = 0.07 or 7.1%

An Investor Anticipates That Inflation Will Be 4 Per Cent