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 the default risk premium on the corporate debt security?
To calculate the real rate earned on the investments, we need to adjust the nominal yield by subtracting the expected inflation rate.
A. Real rate earned on government debt security:
Nominal yield = 5%
Expected inflation rate = 2.5%
Real rate = Nominal yield - Expected inflation rate
Real rate = 5% - 2.5%
Real rate = 2.5%
Therefore, the real rate earned on the government debt security is 2.5%.
Real rate earned on corporate debt security:
Nominal yield = 6.5%
Expected inflation rate = 2.5%
Real rate = Nominal yield - Expected inflation rate
Real rate = 6.5% - 2.5%
Real rate = 4%
Therefore, the real rate earned on the corporate debt security is 4%.
B. The default risk premium on the corporate debt security is the additional yield that investors demand for taking on the higher risk of default compared to government debt. It represents the compensation for the risk of not receiving the full promised payment.
To calculate the default risk premium, we subtract the yield on the government debt security from the yield on the corporate debt security.
Default risk premium = Yield on corporate debt security - Yield on government debt security
Default risk premium = 6.5% - 5%
Default risk premium = 1.5%
Therefore, the default risk premium on the corporate debt security is 1.5%.