Question

There is a financial product A which is guaranteed by government generates 12% annual return. It has no default risk and only exposure to liquidity risk and maturity risk. Assume there is another same term product that provides 2% maturity premium and 1.5% default risk premium. If the expected inflation rate is 3% next year, the real return of one-year treasury note is 2.5%. The implicit liquidity premium compensated by product A is equal to:

Answer 1

Real Return = 2.5 %, Inflation = 3%

Nominal Return = 2.5 + 3 = 5.5 %

For Same Term Product: Maturity Premium = MP = 2 % and Default Risk Premium = DRP = 1.5 %

Total Return = Nominal Return + MP + DRP + Liquidity Premium = 5.5 + 2 + 1.5 + LP = 9 + LP

Product A Return =12 %

Now, Return of Product A = Return of Same Term Product

Nominal Return + LP + MP = 12

LP (of Product A) = 12 - 2 - 5.5 = 4.5 %