You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.5%…

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:

The risk-free rate is the rate of the T-bill so in this case 5.5%. The word real simply means that inflation is factored into the return. Inflation is 3.25%. So to find the real risk-free rate, simply take the 5.50% and subtract the 3.25% thus getting a 2.25% Real Risk-Free Rate.

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