© 2000 John Petroff
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© 2000 John Petroff |
The last component is risk premium. It is that additional percentage charged on a given loan, or required by investors for ownership of a specific stock. This risk component explains the differences in rates of return on comparable financial assets. As can be observed in Table T-2.1 below, rates of return on stocks have been persistently several percentage points above that of corporate bonds, and that of corporate bonds significantly above government bonds. The table clearly shows the relationship that always exists between risk and return. Here, risk is estimated with the help of the standard deviation.
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| Security | Arithmetic mean return | Standard deviation |
| Treasury Bills | 3.1% | 3.1 |
| Government Bonds | 3.1% | 5.7 |
| Corporate Bonds | 5.6% | 5.6 |
| Large Company Stocks | 11.4% | 22.0 |
| Small Company Stocks | 18.1% | 37.3 |
| Inflation | 3.1% | 3.1 |
| Source: Roger G. Ibbotson and Rex A. Sinquefield, "Stocks, Bonds, Bills and Inflation: 1989 Yearbook", Ibbotson Associates, Inc., Chicago, 1989. | ||
The averages presented in Table T-2.1 can only be used for estimating market returns if the inflation rate approximates the one shown in the table. Usually, most recent market averages (i.e. anywhere from 3 months to 10 years) are used instead. In addition, latest yields on money market and government issues can modify recent market averages because they reflect more accurately latest market and economic conditions (i.e. inflation in particular). For estimates of government issues on which to base a riskless rate of return, the most recent data is also preferable to historical long-term statistics. As an example of commonly used financial data, Table T-2.2 reproduces key rates which appeared in the New York Times on Wednesday July 12, 1995.
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| . | Yesterday | Previous day | Year ago |
| Prime rate | 8.75 | 8.75 | 7.25 |
| Discount rate | 5.25 | 5.25 | 3.50 |
| Federal funds | 5.75 | 5.25 | 4.23 |
| 3 months Treasury Bills | 5.37 | 5.4 | 4.44 |
| 6 months Treasury Bills | 5.31 | 5.3 | 4.87 |
| 10 years Treasury Notes | 6.11 | 6.03 | 7.41 |
| 30 years Treasury Bonds | 6.58 | 6.52 | 7.68 |
| Telephone Bonds | 7.48 | 7.45 | 8.48 |
| Municipal Bonds | 6.07 | 6.07 | 6.51 |
| Source: New York Times, Business Section, July 12, 1995. | |||
To compile its Key Rates, the sources quoted in the New York Times include Salomon Brothers and Telerate for Treasury's bellwether bonds, notes and bills, Municipal Bond Index and The Bond Buyer.
The estimation of an appropriate rate of return to use for specific companies has been significantly eased in the past 40 years with the development of modern portfolio theory. This is even more true for estimates of rates to use for stocks, which is described in next section. For debt instruments, the practice of rating by services is described in Chapter 3 Section A.
See research assignment R-D6.1.
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