Howard Keane is a strategist for Dove Investments. His models indicate that the expected inflation rate will be 3.0%. The real rate of return on the S&P 500 index is expected to be 8.7%, while the real rate of return on U.S. Treasury notes is expected to be 1.0%. Howard is interested in the current equity risk premium. Based on the information above, the equity risk premium is closest to:
Click on the arrows to vote for the correct answer
A. B. C.C
To calculate the equity risk premium, we need to subtract the risk-free rate of return from the expected rate of return on the S&P 500 index.
In this case, the expected inflation rate is given as 3.0%. The real rate of return on the S&P 500 index is expected to be 8.7%, and the real rate of return on U.S. Treasury notes is expected to be 1.0%.
The risk-free rate of return is the sum of the real rate of return and the expected inflation rate. Therefore, the risk-free rate of return on U.S. Treasury notes is 1.0% + 3.0% = 4.0%.
Now we can calculate the equity risk premium by subtracting the risk-free rate of return from the expected rate of return on the S&P 500 index:
Equity Risk Premium = Expected Rate of Return on S&P 500 - Risk-Free Rate of Return
Equity Risk Premium = 8.7% - 4.0% = 4.7%
Therefore, the equity risk premium is 4.7%.
None of the provided answer choices match exactly with 4.7%, so we need to select the closest option. Among the given choices, the closest option is A. 4%.
Therefore, the closest option for the equity risk premium is 4%.