Question

Risk-free rate and risk premiums The real rate of interest is currently 3%; the infla- tion expectation and risk premiums for a number of securities follow. P6-8 Inflation expectation Security Risk premium Premium 6% 3% 2 2 D 5 4 E 11 1 a. Find the risk-free rate of interest, RE, that is applicable to each security. b. Although not noted, what factor must be the cause of the differing risk-free rates found in part a? c. Find the nominal rate of interest for each security. ABCA

Answer 1

The risk-free rate for each security is calculated below: Security Inflation Premium Real rate of interest (Y) 3% 3% 6% 9% 8% 5% 11% Risk free rate of interest (X) + (V) 9% 12% 11% 8% 14% 3% 3% 3% b. The cause for different risk-free rates would be different maturity periods for each security as the inflation rates are different. C. The nominal rate of interest for each security is calculated below: Security Inflation Premium (X) Real rate of interest Risk premium (2) 3% 6% 9% 8% 5% 11% 3% 3% 3% Risk free rate of interest (X) + (V) +(2) 12% 14% 13% 12% 15% 2% 3% 2% 4% 1%