Question

For a given bond, you have the following information: Real risk-free rate (k*)=3%, inflation premium = 8%, default risk premium = 2%, liquidity premium = 2%, and maturity risk premium = 1%. What is the nominal risk-free rate (kRF)?

Answer 1

There are two methods to solve this, 1) Simple method or approximation method and 2) Geometric averaging (As we don’t have option here, we will solve by both)

Please pick either of two which is appropriate for as per your answering guidelines:

1)

Nominal risk free rate = Risk free rate + Inflation risk premium = 3% + 8% = 11.00%

OR use below geometric averaging:

2) Nominal risk free rate = (1+Risk free rate) x (1+Inflation premium) -1

= (1+3%) x (1+8%) -1 = 11.24%