The table below shows the difference in returns between stocks and treasury bill

Question

The table below shows the difference in returns between stocks and treasury bills and the difference between stocks and treasury bonds at ten year intervals:
(table)
Years Stocks vs. Bonds Stocks vs. Bills
1964-73 3.7% 8.3%
1974-83 0.2% 8.6%
1984-93 7.5% 5.4%
1994-2003 4.8% 2.1%

a) At the end of 1973, the yield on Treasury Bonds was 6.6% and the yield on T-bills was 7.2%. Using these figures and the historical data above from 1964-73, construct 2 estimates of the expected return on equities as of Dec. 1973.
b) At the end of 1983, the yield on Treasury bonds was 6.6% and the Yield on the bill was 7.2% Using these figures and the historical data above from 1974-83, construct 2 estimates of the expected return on equities as of Dec. 1983.
c)At the end of 1993, the yield on Treasury bonds was 6.6% and the Yield on the bill was 2.8% Using these figures and the historical data above from 1984-93, construct 2 estimates of the expected return on equities as of Dec. 1993.
d)At the end of 2003, the yield on Treasury bonds was 5.0% and the Yield on the bill was 1.0% Using these figures and the historical data above from 1994-2009, construct 2 estimates of the expected return on equities as of Dec. 2003.
e) What lessons do you learn from this excercise? How much do your estimates of the ecpected return on equities vary over time and why do they vary?

Explanation / Answer

CAPM Model:Expected return=Rf+B[E(Rm)-Rf]

where, Rf:Return from risk free securities; E(Rm):Expected return on market securities

B:systematic risk; Rp:Risk premium=Rm-Rf and rm-Rf=B*Rm

e) from the abvove expected returns in case of treasury bonds are fluctuating over the period as there are deviations in risk free return and in case of treasury bills also fluctuations in expected returns are due to the deviations in risk free return rate. The expected return on securities is more ands increasing with high risk free return values also B value show adverse impact on it.

NOTE: It is better to provide systematic risk values in these type of problems for measuring the expected returns using CAPM model.

Year      StocksVsBonds     StocksVsBills 1964-73 3.70% 8.30% 1974-83 0.20% 8.60% 1984-93 7.50% 5.40% 1993-2003 4.80% 2.10%

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