What is the risk premium for a bond having a coupon of 7% when the expected interest rate is 14%?
Bond Risk Premia:
A bond is subject to several risks, including default risk, maturity risk, inflation risk and liquidity risk. To compensate for these risks, a bond must offer investors a higher return, and this excess return is called the risk premium.
Answer and Explanation:
The risk premium of a bond is the difference between the bond's yields and the yield on comparable but risk-free bond. To determine the risk premium, we first need to identity what the comparable risk-free bond should be and the return on such a bond. Typically, the treasury bonds of the same term to maturity is used as a proxy for risk-free bonds, because treasury bonds are considered from from default, and are also highly liquid.
In this question, we know the yield on the bond is 14%. But we do not know the yield on the treasury bonds of similar term to maturity. For the sake of illustration, suppose the yield on similar treasury bonds is 8%, then the risk premium is:
- risk premium = 14% - 8% = 6%
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from Financial Accounting: Help and ReviewChapter 5 / Lesson 26