Question

The Gran Group's 5-year bonds yield 6.85%, and 5-year T-bonds yield 4.75%. The real risk-free rate is r* = 2.80%, the default risk premium for Gran's bonds is DRP = 0.85% versus zero for T-bonds, the liquidity premium on Gran's bonds is LP = 1.25%, and the maturity risk premium for all bonds is found with the formula MRP = (t ? 1) × 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on 5-year bonds?

Answer 1

Solution:
	The inflation premium (IP) on 5-year bonds = 1.55%
Working Notes:
	Corporate bond yield = r = rf + IP + MRP + DRP + LP
	r Gran= r* + IP + MRP + DRP + LP
	6.85% = 2.80% + IP + 0.40 % + 0.85% + 1.25%
	IP = 6.85% - 5.30%
	IP=1.55%
Notes:	MRP = (t-1) x 0.1%
	t= 5 years
	MRP = (t-1) x 0.1%
	=(5-1) x 0.1%
	=4 x 0.1%
	=0.40 %
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