The calculated value of security's equilibrium rate of return is 12.35%.
Here, security's equilibrium rate of return:
= Real interest rate + inflation risk premium + default risk premium + liquidity risk premium + maturity risk premium
ij* = 2.75% + 5.50% + 3.00% + 0.25% + 0.85%
= 12.35%
Risk Premium & Security's Equilibrium Rate of Return:
Security's equilibrium rate of return is the return required by investors from investment in the security. The equilibrium rate of return is calculated by adding the risk-free rate to the sum of all risk premiums consisting of default risk, liquidity risk, maturity risk and inflation risk.
The inflation risk premium :
is a measure of the premium investors require for the possibility that inflation may rise or fall more than they expect over the period in which they hold a bond.
What is the formula of risk premium?
The estimated return minus the return on a risk-free investment is equal to the risk premium. For example, if the estimated return on an investment is 6 percent and the risk-free rate is 2 percent, then the risk premium is 4 percent.
What is security equilibrium?
Briefly, the requirement for a security equilibrium is that it is "common. knowledge" that no player will settle for a payoff, under any contingency, which is less. than his security level given the occurrence of that contingency.
The question is incomplete. Missing part of question is:
the real risk-free rate is 5.50 percent. The security's liquidity risk premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has no special covenants. Calculate the security's equilibrium rate of return
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