Based on the following information, calculate: Real risk-free rate of interest = 2.75% Inflation Premium =...

Based on the following information, calculate:

Real risk-free rate of interest = 2.75%

Inflation Premium = 1.75%

Default Risk Premium = 1.25%

Liquidity Premium = 0.5%

Maturity Risk Premium = 0.75%

If this were a long-term Treasury security, or T-bond, what would be the nominal risk-risk free rate on a T-bond?

Expert Solution

A one year U.S. Treasury bill (T-Bill) only reflects the real risk free rate and the inflation rate. The other risk premiums are not appropriate for a U.S. Treasury bill or T bond.

T-bills do not have Default Risk Premium since the federal government issues the security and cannot default. They can just print more money and pay the debt. [by printing more money, the federal government can avoid default, but will cause other problems…just google on your own to read why]

T-bills do not have Liquidity Risk Premium since it is easy to trade the securities. Liquidity risk premium is probably more appropriate for a corporate bond which has no trading market (i.e. it’s hard to sell, thus you have no liquidity)

T-bills are short-term by definition and the problem suggests they are one-year. At this time frame, the maturity risk premium is probably zero or very close to it. I thought Figure 6-5 in Kricket’s pdf she linked explained this quite well.

r* + IP = rRF = nominal risk-free rate (T-bill rate)
r* = real risk-free rate
IP = inflation premium (the average of expected future inflation rates)
DRP = default risk premium
MRP = maturity risk premium
LP = liquidity premium

r* + IP = rRF = nominal risk-free rate (T-bill rate)

r* = real risk-free rate	2.75%

Inflation Premium	1.75%

nominal risk-risk free rate	4.50%

jeff jeffy answered 2 years ago

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