im confused on calculating default-risk premuim and maturity- risk premiums. like how does this formula work...

im confused on calculating default-risk premuim and maturity- risk premiums. like how does this formula work : NI= RI+IP+DP+ MP+LP and why are some excluded when finding treasurey bonds or corporate bonds.if im giving the yield.... would that be the nominnal interest rate and if i am given two yields one from treasurey and another from corporate why do we ignore the treasury bond and solve for corporate instead ?

Expert Solution

We have following equation to calculate the nominal interest rate

NI =RI + IP + DP + MP + LP

Where,

NI = Nominal interest rate or required return or current yield

RI = real risk free rate of return

IP = Inflation premium

MP = maturity risk premium

DP = default risk premium

LP = Liquidity premium

Other important consideration in nominal interest rate calculations:

· In the case of T-bills; it is exposed to inflation risk only, therefore only inflation premium (IP) over the real risk free rate is applicable (maturity of T-bills are one year or less so no maturity risk and there is no default risk and liquidity risk because of sovereign guarantee). To calculate the current yield on T-bills; our equation will become

NI = RI + IP

· In the case of a T-bond; there is only inflation risk and maturity risk (there is no default risk and liquidity risk because of sovereign guarantee), therefore equation become

NI = RI + IP + MP

Maturity risk premium associated with the maturity of the bond therefore maturity time is a factor in calculating the maturity risk premium

· In the case of a corporate bond; there are inflation risk, default risk, maturity risk and liquidity risk, therefore equation become

NI = RI + IP + DP + MP +LP

jeff jeffy answered 1 year ago

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