Which of the following equations is INCORRECT?
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A. B. C. D.A
The real Risk-Free Rate = [(1 + nominal Risk-free Rate) divided by (1 + inflation rate)] "" 1. The other equations are correct.
Let's analyze each equation and determine if it is correct or incorrect:
A. Real Risk-Free Rate = [(1 + nominal Risk-Free rate) * (1 + inflation rate)] - 1.
This equation is correct. The real risk-free rate is calculated by adding 1 to the nominal risk-free rate and multiplying it by 1 plus the inflation rate, then subtracting 1. The real risk-free rate adjusts the nominal risk-free rate for the effects of inflation, providing a measure of the actual return an investor can expect to earn in a risk-free investment after accounting for inflation.
B. Expected Return (SML) = Rnominal Risk-Free + (RMarket - Rnominal Risk-Free) * Beta.
This equation is correct. The expected return according to the Security Market Line (SML) is calculated by adding the nominal risk-free rate to the product of the market risk premium (RMarket - Rnominal Risk-Free) and the beta of the investment. The SML is a graphical representation of the relationship between risk and expected return for individual securities.
C. Required Return (nominal) = [(1 + Risk-Free Rate (real)) * (1 + Expected Inflation) * (1 + Risk Premium)] - 1.
This equation is correct. The required return in nominal terms is calculated by multiplying the real risk-free rate by 1 plus the expected inflation rate, and then multiplying the result by 1 plus the risk premium. Subtracting 1 gives the required return in nominal terms. This equation adjusts the risk-free rate for inflation and incorporates the risk premium to determine the required return on an investment.
D. Risk premium (Fundamental view) = total risk = business risk + financial risk + liquidity risk + exchange rate risk + country risk.
This equation is incorrect. The equation mixes up the concepts of risk premium and total risk. The risk premium represents the excess return that investors expect to earn over the risk-free rate as compensation for taking on additional risk. On the other hand, total risk is the overall variability or uncertainty associated with an investment and is typically decomposed into components such as business risk, financial risk, liquidity risk, exchange rate risk, and country risk. The equation should have stated that total risk is the sum of these various components, not the risk premium.
In summary, the incorrect equation is D.