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Geometric vs arithmetic average

Geometric average always less than or equal to arithmetic average


The Risk Premium For Arithmetic Returns

Average rate of return for equity minus risk free interest rate


When decisions are being taken on a forward-looking basis

The arithmetic mean (rA) is the appropriate measure


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


When to use geometric average

• When past performance is being considered


How to Find Relation Between Risk and Return?

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


Investors demand compensation for

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


Equity Risk premium

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


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