1. Interest rates A particular security's default risk premium is 3 percent. For all securities, the inflation risk premium is 2 percent and the real interest rate is 2.25 percent. The security's liquidity risk premium is 0.75 percent and maturity risk premium is 0.90 percent.
The security has no special covenants. What is the security's equilibrium rate of return?
To find the security's equilibrium rate of return, you need to add up all the different risk premiums to the real interest rate.
The equilibrium rate of return formula is:
Equilibrium Rate of Return = Real Interest Rate + Inflation Risk Premium + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium
Given information:
Real Interest Rate = 2.25%
Inflation Risk Premium = 2%
Default Risk Premium = 3%
Liquidity Risk Premium = 0.75%
Maturity Risk Premium = 0.90%
Now let's substitute these values into the equation:
Equilibrium Rate of Return = 2.25% + 2% + 3% + 0.75% + 0.90%
Adding these values together:
Equilibrium Rate of Return = 2.25% + 2% + 3% + 0.75% + 0.90% = 8.90%
Therefore, the security's equilibrium rate of return is 8.90%.