You are considering an investment in a one-year government debt security with a yield of 5 percent or a highly liquid corporate debt security with a yield of 6.5 percent. The expected inflation rate for the next year is expected to be 2.5 percent.


a. What would be your real rate earned on either of the two investments?

b. What would be the default risk premium on the corporate debt security?

To answer these questions, we need to understand the concept of real rate of return and default risk premium.

a. The real rate of return represents the return earned on an investment adjusted for inflation. We can calculate the real rate earned on either investment by subtracting the expected inflation rate from the nominal yield.

For the government debt security:
Real Rate = Nominal Yield - Inflation Rate
= 5% - 2.5%
= 2.5%

For the corporate debt security:
Real Rate = Nominal Yield - Inflation Rate
= 6.5% - 2.5%
= 4%

Therefore, the real rate earned on the government debt security is 2.5% and on the corporate debt security is 4%.

b. The default risk premium is the additional yield or return investors demand for bearing the risk of default on a corporate debt security compared to a risk-free government debt security. It compensates investors for the higher likelihood of not receiving full interest and principal payments.

To find the default risk premium on the corporate debt security, we need to find the difference between the yield of the corporate debt security and the yield of the government debt security:

Default Risk Premium = Yield of Corporate Debt Security - Yield of Government Debt Security
= 6.5% - 5%
= 1.5%

Therefore, the default risk premium on the corporate debt security is 1.5%.