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, assuming maturity risk premium and liquidity premium to be zero?
a) To calculate the real rate earned on each investment, we need to adjust the nominal yield for inflation.
For the one-year government debt security with a yield of 5 percent, the real rate can be calculated as follows:
Real Rate = Nominal Yield - Inflation Rate
= 5% - 2.5%
= 2.5%
So, the real rate earned on the government debt security is 2.5%.
For the highly liquid corporate debt security with a yield of 6.5 percent, the real rate can be calculated similarly:
Real Rate = Nominal Yield - Inflation Rate
= 6.5% - 2.5%
= 4%
So, the real rate earned on the corporate debt security is 4%.
b) The default risk premium on the corporate debt security is the additional return investors require to compensate for the risk of default by the issuing company. Assuming zero maturity risk premium and liquidity premium, we can calculate the default risk premium as follows:
Default Risk Premium = Nominal Yield - Risk-Free Rate
= 6.5% - 5%
= 1.5%
Therefore, the default risk premium on the corporate debt security is 1.5%.