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1. [Inflation and Risk Premiums] Voice River, Inc. provides media-on-demand services via the Internet. Management has...

1. [Inflation and Risk Premiums] Voice River, Inc. provides media-on-demand services via the Internet. Management has been studying current interest rates. A lender is willing to make a two-year loan to Voice River at a 12 percent annual interest rate. The U.S. government is currently paying 8 percent annual interest on its two-year securities.

A.     If the real rate of interest is expected to be 3 percent annually, what is the inflation premium expected at this time?

B.     What is the amount of the total risk premium that Voice River will have to pay?

C.    If a 1 percent liquidity premium is built into the 12 percent rate, what is the default risk premium on the loan?

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Answer #1

1. If the real rate of interest is expected to be 3 percent annually, what is inflation premium expected at this time?

Formula = Risk free Rate = Real rate + Inflation Premium

= 8% - 3% = 5%

2. What is the amount of the total risk premium that Voice River will have to pay?

Formula =nominal interest rate – Risk free Interest rate

= 12% - 8% = 4%

3. If a 1 percent liquidity premium is built into the 12 percent rate, what is the default risk premium on the loan?

Formula: Risk Premium – Liquidity Premium

= 4% - 1% = 3%

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