6. 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?
Now I am not looking for the answer. I am looking for the formula or equation to solve it. If you can explain that to me I would appreciate it.
To solve this problem, we need to use the concept of real rate of return and default risk premium. Let's break down the formulas for each calculation:
a. Real rate earned formula:
Real rate earned on an investment is the nominal rate of return minus the inflation rate. The formula to calculate the real rate earned is:
Real rate earned = Nominal rate of return - Inflation rate
In this case, the nominal rate of return can be the yield on the government debt (5 percent) or the yield on the corporate debt (6.5 percent).
The inflation rate given is 2.5 percent.
b. Default risk premium formula:
Default risk premium measures the additional yield that investors demand to compensate for the risk of default in corporate debt securities. The formula to calculate the default risk premium is:
Default risk premium = Yield on the corporate debt - Yield on the risk-free government debt
In this case, the yield on the corporate debt is given as 6.5 percent, and the yield on the risk-free government debt is 5 percent.
Once you have the formulas, you can plug in the given values to calculate the real rate earned and the default risk premium.