Crockett Corporation'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 Crockett's bonds is DRP = 0.85% versus zero for T-bonds, the liquidity premium on Crockett'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?

Question

Quizplus · Accepted Answer

First, we need to calculate the total premium on Crockett's bonds: 
Total premium = DRP + LP + MRP 
Total premium = 0.85% + 1.25% + (4-1) * 0.1% 
Total premium = 2.95%

Next, we can use the Fisher equation to calculate the inflation premium: 
Nominal rate = Real rate + Inflation premium 
6.85% = 2.80% + Inflation premium 
Inflation premium = 4.05%

Finally, we can subtract the inflation premium from the nominal rate to get the real rate: 
Real rate = Nominal rate - Inflation premium 
Real rate = 6.85% - 4.05% 
Real rate = 2.80%

Now we can compare the real rate of Crockett's bonds (2.80%) to the real rate of T-bonds (2.80% because there is no default risk premium): 
Crockett's real rate = 2.80% 
T-bond's real rate = 2.80%

Since the only difference between the two bonds is the default risk premium, we can conclude that Crockett's bonds are the best choice for investors who are willing to take on some default risk to earn a higher yield. Therefore, the best choice is Crockett's bonds.

Crockett Corporation's 5-Year Bonds Yield 6