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1

Geometric vs arithmetic average

Geometric average always less than or equal to arithmetic average

2

The Risk Premium For Arithmetic Returns

Average rate of return for equity minus risk free interest rate

3

When decisions are being taken on a forward-looking basis

The arithmetic mean (rA) is the appropriate measure

4

Why arithmetic mean is better for forward-looking

• Represents the mean of all the returns that may possibly occur over the investment holding period
• Best estimator of expected (short-term) future return
• The best gauge of the expected risk premium - Expected return above risk free interest rate

5

When to use geometric average

• When past performance is being considered

6

How to Find Relation Between Risk and Return?

• Have a look at the historical records – returns – for assets with different risks
• Caveat

7

Investors demand compensation for

1. Abstaining from consuming today and waiting until tomorrow
2. Taking on risk – measured by the risk premium

8

Equity Risk premium

Difference between the return on equities and the return on a risk-free asset, typically treasury bills (and government bonds)

9

The risk premium matters because it is central to

- Projecting future investment returns
- Calculating a company’s cost of equity capital
- Valuing companies and shares
- Appraising investment projects
- Determining fair rates of return for regulated utilities