Answers for a 10 year us treasury bond has a 3.50 % interest rate, while a same maturity corporate bond has a 5.25 % interest rate. Real interest rates and inflation rate expectations would be for the two bonds. if default risk premium of 1.50 percentage points is estimated for the corporate bond, determine liquidity premium for corporate bond
To determine the expected real interest rates and inflation rate expectations for the two bonds, we will need to calculate the inflation premium and subtract it from the nominal interest rates.
First, let's calculate the expected inflation rate:
Inflation Rate = Nominal Interest Rate - Real Interest Rate
For the 10-year US Treasury bond:
Real Interest Rate = 3.50% (given)
Inflation Rate = Nominal Interest Rate - Real Interest Rate = 0
The 10-year US Treasury bond is considered to have a risk-free rate, so its inflation premium is expected to be zero.
For the corporate bond:
Nominal Interest Rate = 5.25% (given)
Real Interest Rate = ?
Inflation Rate = ?
Since we don't have the actual real interest rate or the inflation rate for the corporate bond, we cannot directly calculate them. However, we can estimate the inflation premium using the default risk premium.
Default Risk Premium = Nominal Interest Rate - Risk-Free Rate
Risk-Free Rate = 3.50% (rate for the US Treasury bond)
Default Risk Premium = 1.50% (given)
Now, let's calculate the inflation premium for the corporate bond:
Inflation Premium = Default Risk Premium - Real Interest Rate
Inflation Premium = 1.50% - Real Interest Rate
Since we don't have the real interest rate, we can't directly compute the inflation premium. However, if we assume that the default risk premium reflects the additional return demanded by investors to compensate for the higher risk of default, we can assume that the inflation premium is approximately equal to the default risk premium. Therefore:
Inflation Premium ≈ Default Risk Premium = 1.50%
Now, we can estimate the inflation rate and the real interest rate for the corporate bond:
Inflation Rate = Inflation Premium + 0 (approximation for the risk-free rate of the US Treasury bond)
Real Interest Rate = Nominal Interest Rate - Inflation Rate
Inflation Rate = 1.50%
Real Interest Rate = 5.25% - 1.50% = 3.75%
To determine the liquidity premium for the corporate bond, we need additional information. The liquidity premium represents the additional return investors demand for investing in an illiquid bond compared to a highly liquid bond. It is challenging to estimate the liquidity premium without specific data or market conditions. Therefore, without more details, we cannot determine the liquidity premium for the corporate bond.