Question

What is the nominal return on short-term corporate paper if the liquidity premium is 0.5%, the default risk premium is 0.7%, and the inflation rate is 1.4%? Assume 0% real return.

Assume both A and B Factory sell short-term corporate paper to investors. If A Factory's yield to investors is 3% and B's is 4.3%, and both companies sell 3-month paper, what factor explains this difference?

Answer 1

Given Information:

Real return = 0%

Liquidity premium = 0.5%

Default risk premium = 0.7%

Inflation rate = 1.4%

Notes:

1. Real return - Real return is the return an investor receives after the rate of inflation is taken into account. e.g. If a security is paying 5% interest but inflation is 2%, then the real return will be 3% (5 - 2).

2. Inflation rate - Inflation rate represents the increase in cost of goods during a period. Inflation effectively erodes a portion of return due to goods becoming dearer.

3. Liquidity premium - Liquidity premium is the additional return required by investor due to the illiquid nature of the security. An asset which cannot be sold easily due to restrictions such as lack of trading, regulatory restriction etc. will demand a higher liquid premium. Examples of illiquid assets are land, real estate, antiques, cars etc.

4. Default risk premium - Default risk premium compensates an investor for the likelihood of default. If a security has a lower credit rating, the investor will demand a higher risk premium.

a. Calculation of nominal return:

Nominal return is the return generated by a security before factoring taxes, inflation or other fees. Hence, nominal & real return are related as follows -

Real return = Nominal return - Inflation rate.

However, liquidity & default risk premium will be added to arrive at nominal return.

Hence, Nominal return = Real return + Inflation rate + Liquidity premium + Default risk premium

Nominal return = 0% + 1.4% + 0.5% + 0.7%

Nominal return = 2.6%

b. Factor to explain the difference between yield to investors:

Factory A's yield to investor is 3% whereas B is 4.3%. The difference can be due to following factors:

1. Liquidity premium - If the company is a private company, the securities can be illiquid to trading restrictions. Hence, if factory A is a listed company while B is a private company, they can have different liquidity premiums.
2. Default risk premium - If one company's credit rating is lower than the other company, it will have a higher risk premium.
3. Real return - The company could be offering different returns on the corporate paper based on their purpose of issue & yield on proceeds.