Riordan Services Inc. just issued a 2-year bond at a 15% interest rate. Riordan's default risk premium has been estimated at 2.5%, its liquidity risk premium is about 2%, and its maturity risk premium is 3%. Inflation is expected to be 5% in the bond's first year and 4% in its second year. What is the implied pure rate of interest?

Question

Quizplus · Accepted Answer

The implied pure rate of interest is 3%. This is because the bond's yield to maturity is 15%, and the default risk premium is 2.5%, the liquidity risk premium is 2%, and the maturity risk premium is 3%. Inflation is expected to be 5% in the bond's first year and 4% in its second year. So, the real yield to maturity is 3%.