6. You are considering an investment in a one-year government debt

Question

security with a yield of 5 percent or a highly liquid corporate debt
security with a yield of 6.5 percent. The expected inflation rate for
the next year is expected to be 2.5 percent.
a. What would be your real rate earned on either of the two
investments?
b. What would be the default risk premium on the corporate
debt security?

Answer 1

a. Real rate on return
Government Debt Security=5%-2.5%=2.5%
CD=6.5%-2.5%=4%

b. risk premium
6.5%-5%=1.5%
Adjustment for inflation
1.5%-2.5%= -1%