Mirtha Mudflat has sufficient funds to choose one of two investments.The same amount will be invested in either case.Choice one: ten year $100,000 5% Treasury bonds issued to yield 4% per annum,the market rate.Choice two: a risky bond of the same amount that has expected cash flows of $9,000 per year for the same period. What is the risk premium that makes Mirtha indifferent between the two investments?

Question

Quizplus · Accepted Answer

The risk premium is the difference between the yield of the risky bond and the yield of the risk-free bond. The risk-free bond yields 4% per annum. The risky bond has expected cash flows of $9,000 per year, which is equivalent to a yield of 9% on a $100,000 investment. Therefore, the risk premium is 9% - 4% = 5%. However, the correct calculation involves finding the yield that equates the present value of the risky bond's cash flows to the present value of the Treasury bond, which results in a risk premium of 3.80%.

Mirtha Mudflat Has Sufficient Funds to Choose One of Two