Question

Problem 1 (10 points) FIN300 Inc.'s 5-year bonds yield 7.50% and 5-year T-bonds yield 4.90%. The real risk-free rate is r*- 2.5%, the default risk premium for FIN300's bonds is DRP 0.40%, the liquidity premium on FIN300's bonds is LP-2.2% versus zero on T-bonds, and the inflation premium (IP) is 1.5%. What is the maturity risk premium (MRP) on all 5-year bonds?

Can I please also have the formulas included with the answer? Thanks!

Answer 1

Solution-

5 year bond yield (r)= 7.50%

5 year T bond yield (rt) =4.90%

Real risk free rate (r*)= 2.5%

Default risk premium ( DRP) =0.40%

Liquidity Premium (LP) = 2.2%

Inflation premium (IP)= 1.5%

Market risk premium (MRP) =?

r= r*+DRP+LP+IP+MRP

7.50%= 2.5%+0.40%+2.2%+1.5%+MRP

MRP = 7.5%-2.5%-0.40%-2.2%-1.5%= 0.90%

OR

rt= r*+ IP+MRP

4.90%= 2.5%+1.5%+ MRP

MRP = 4.90%-2.5%-1.5%= 0.90%

Maturity Risk Premium on 5 year bond = 0.90%