Question

1.) Camden Oil Corp bonds (AA rated) mature in 2 and 10 years respectively. The 2 year bond yields 6.0% and the 10 year yields 6%. Two year US government bonds yield 1.5% and 10 year US government bonds yield 3.3%. What is the risk premium for Camden Oil Corp 10 year bonds?

2.) Camden Oil Corp bonds (AA rated) mature in 2 and 10 years respectively. The 2 year bond yields 7.3% and the 10 year yields 9%. Two year US government bonds yield 1.5% and 10 year US government bonds yield 4.0%. What is the 2 year risk free bond yield?

3.) A banker must earn at least a 3.5% return after expected inflation on short term loans. The inflation rate for the past 6 months has averaged 7.1%. The expected inflation rate for the next twelve months is 2.8%. Nominal interest rates for short term loans were 8.8% last month. What is the minimum nominal interest rate that he should charge for a one year loan?

Answer 1

Risk Premium is the difference between what the bond is earning and the Risk free investments retuen that is the US government bonds.

1. Risk premium for 10 year old bond is 6%-3.3%=2.7%

2. Risk free return for 2 year bond is 1.5%

3. The nominal rate of interest for one year loan is 8.8% if inflation of 2.8% is added to it would give us the real rate of interest that is 9.04% if the banker must earn at least a 3.5% return after expected inflation on short term loans then he should charge 9.04%+3.5% that is 12.55%