Investors require a 4 percent return on risk-free investments. On a particular risky investment, investors require an excess return of 7 percent in addition to the risk-free rate of 4 percent. What is this excess return called?

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BlackTom AI · Accepted Answer

We start by restating the core scenario: investors require a 4 percent return on risk-free investments, and for a particular risky investment they require an additional 7 percent on top of that risk-free rate. 
Option 1: Inflation premium. This is the extra return investors demand to compensate for expected inflation, not the extra return due to taking on risk. In the problem, the extra amount is explicitly described as an addition to the risk-free rate due to risk, not inflation. 
Option 2: Required return. This term generally refers to the total return investors demand for an investment, which can include both the risk-free portion and any risk premia. It is not the label for the additional amount above the risk-free rate itself. 
Option 3: Real return. Real return adjusts for inflation and represents purchasing power, not a premium for risk. The 7 percent here is about risk compensation, not inflation-adjusted performance. 
Option 4: Average return. This is a generic measure of past or expected typical returns and has no direct association with the specific risk compensation over the risk-free rate described in the scenario. 
Option 5: Risk premium. This is the term for the extra return demanded for bearing risk beyond the risk-free rate. In the given setup, the 7 percent is precisely the additional reward investors require for taking on risk, separate from the 4 percent risk-free rate. 
In summary, the only option that aligns with the concept of an extra return earned for assuming risk above the risk-free rate is the risk premium.

FNBSLW 344-23 Chapter 10 Practice Quiz (not graded)

Investors require a 4 percent return on risk-free investments. On a particular risky investment, investors require an excess return of 7 percent in addition to the risk-free rate of 4 percent. What is this excess return called?

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