Question

A particular security’s default risk premium is 4 percent. For all securities, the inflation risk premium is 3.65 percent and the real risk-free rate is 2.50 percent. The security’s liquidity risk premium is 0.35 percent and maturity risk premium is 0.95 percent. The security has no special covenants. Calculate the security’s equilibrium rate of return. (Round your answer to 2 decimal places.)

Answer 1

SOLUTION :

The values provided in the question are as follows:

default risk premium = 4 percent. or 4 %

inflation risk premium = 3.65 percent or 3.65 %

real risk-free rate = 2.50 percent or 2.50%

liquidity risk premium = 0.35 percent or 0.35 %

maturity risk premium = 0.95 percent or 0.95 %

security’s equilibrium rate of return = ?

Investor can earn risk free rate of return .If investor want earn more then he will take more risk . It is a well known fact that high return are possible only by investment in high risky area.

Risk Premium is the excess of risk free rate of return.Investors bears the risks .Return is the reward for the investors.Risk can be form of default risk,inflation risk , liquidity risk ,maturity risk etc.

The formula to calculate the security’s equilibrium rate of return is as follows :

security’s equilibrium rate of return = default risk premium + inflation risk premium +  real risk-free rate + liquidity risk premium + maturity risk premium

security’s equilibrium rate of return = 4 % + 3.65 % + 2.50% + 0.35 % + 0.95 %

security’s equilibrium rate of return = 11.45 %

Hence,the security’s equilibrium rate of return = 11.45 %