Table 123

Average Annual Returns and Risk Premiums: 1926-2000

Slide 12.12

Source: © Stocks, Bonds, Bills, and Inflation 2001 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

The government borrows money by issuing bonds. These bonds come in different forms. The ones we will focus on are the Treasury bills. These have the shortest time to maturity of the different government bonds. Because the government can always raise taxes to pay its bills, the debt represented by T-bills is virtually free of any default risk over its short life. Thus, we will call the rate of return on such debt the risk-free return, and we will use it as a kind of benchmark.

A particularly interesting comparison involves the virtually risk-free return on T-bills and the very risky return on common stocks. The difference between these two returns can be interpreted as a measure of the excess return on the average risky asset (assuming that the stock of a large U.S. corporation has about average risk compared to all risky assets).

We call this the "excess" return because it is the additional return we earn by moving from a relatively risk-free investment to a risky one. Because it can be interpreted as a reward for bearing risk, we will call it a risk premium.

Using Table 12.2, we can calculate the risk premiums for the different investments; these are shown in Table 12.3. We report only the nominal risk premiums because there is only a slight difference between the historical nominal and real risk premiums.

The risk premium on T-bills is shown as zero in the table because we have assumed that they are riskless.

risk premium

The excess return required from an investment in a risky asset over that required from a risk-free investment.

0 0

Post a comment