The market has an expected rare of return of 9.8%. The long term government bond is expected to yield 4.5% and the US Treasury bill is expected to yield 3.4%. The inflation rate is 3.1% What is the market risk premium?

6.4%

Explanation:

market risk premium = market rate - risk free rate

market risk premium = 9.8% - 3.4% = 6.4%

The risk free rate is based on the T-bill's rate because they virtually risk free securities. Some people used to use the long term government bond yield as the risk free rate but since the US government's long term debt was downgraded a few years ago, normally most people use the T-bill rate right now. T-bills are short term securities that are paid at par value, which means that the yield depends on the selling price. E.g. a $10,000 T-bill will pay $10,000 on maturity, which eliminates any type of interest rate risk. Any investor holding a T-bill can sell it on secondary markets at any time, so they are extremely liquid.

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