risk premiums by 4RrPF8

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									                         Determinants of Nominal (Quoted) Interest Rate

Nominal Interest rate (R) =Real Interest rate (r*) + inflation premium +default premium
+maturity premium

Why do we have premiums? : To compensate the lender against different types of risks.

Inflation premium: to compensate the lender for the expected inflation during the life of the loan.

Default risk premium: to compensate the lender for the risk that the borrower might not return the
money back. Higher the default risk the higher is the default premium.

Maturity risk premium: to compensate the lender against the waiting time until he gets his money
back. The longer the waiting time (maturity), the higher is the maturity premium.

Risk free asset: earns risk free rate (rf) which is equal to rf=r*+inflation premium, because they have
zero default risk and are for short term so the maturity premium is also zero. e.g. Treasury bills.

Treasury bonds have zero default risk because they are backed by the government, but have maturity
premium because they are long term.e.g.30 years Treasury bond.

Corporate bonds are issued by corporations and are usually long term bonds so they will have both
default and maturity premiums. The better the bond credit rating, the lower the default risk. Corporate
bonds credit rating ranges from AAA to BBB to CCC and so on. The lowest default risk (lowest
default premium) will be for AAA corporate bond. Therefore, the difference between the nominal
interest rate of Treasury bond and that of corporate bond with same maturity and other features is the
default risk premium.

The difference between the nominal interest rate of two corporate bonds with the same credit rating
(equal default risk premium) and other features but different maturities is the maturity risk premium.

Examples:

1. Shaky Company has just issued a five year bond with interest rate of 9%, while Stable Company
has issued an identical five year bond with interest rate of 7%.What could be a reason for the
difference between the two bonds interest rate? Default Risk Premium.

2. Estimate the maturity premium if the interest rate of 30 year corporate bond is 15% and the interest
rate of 20 year corporate bond is 10%, given that both have the same credit rating.

Maturity premium =5%.

3. Estimate the default premium and the maturity premium, given that the risk free rate is 4%, 10
years Treasury bond is 6% and a BBB 10 years corporate bond is 8%.

Default premium = 2%

Maturity premium = 2%

								
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