Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Question
When would I use the arithmetic average risk premium (as opposed to the geometric risk premium)?
Expert Solution
Step 1: Meaning of arithmetic average risk premium and geometric risk premium
The arithmetic average risk premium is calculated as the difference between the average return of an investment or portfolio and the risk-free rate of return. It is computed by taking the average of the periodic returns over a specific time period. The arithmetic average is a simple average that does not account for the compounding effect of returns over time.
The geometric risk premium, on the other hand, is calculated using the geometric mean of the returns. It considers the compounding effect of returns over time and provides a more accurate measure of the actual growth rate of an investment.
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