Question

Medium Size Retailer Corporation's (MSRC) 5-year bonds yield 8.25%, and 5-year T-bonds yield 4.50%. The real risk-free rate is r* = 2.45%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for MSRC's bonds is DRP = 2.65% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) x 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on MSRC's bonds? Enter your answer rounded to two decimal places. Do not enter % in the answer box. For example, if your answer is 0.12345 or 12.345% then enter as 12.35 in the answer box.

Answer 1

The required return on a debt security can be calculated by the following formula,

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

where,

r = reqd return on a debt security

r* = real risk-free rate of interest

IP = Inflation Premium

MRP = Maturity Risk Premium

DRP = Default Risk Premium

LP = Liquidity Premium

MRP = (t-1) * 0.1%

t = time period

MRP = (5-1) * 0.1% = 0.4%  

r = 8.25%

r* = 2.45%

IP = 1.65%

DRP = 2.65%

LP = 8.25% - ( 2.45% + 1.65% + 2.65% + 0.4%)

= 8.25% - 7.15%

= 1.1%

Hence the liquidity premium on MSRC's bonds is 1.1

If you have any doubts please let me know in the comments.