Suppose that a 5-year Treasury bond pays an annual rate of return of 1.3%, and a 5-year bond of the fictional company Risky Investment Inc. pays an annual rate of return of 7.1%. The risk premium on the Risky Investment bond is ______ percentage points.

Consider a decrease in the annual rate of return on the Risky Investment bond from 7.1 percent to 5.5 percent. Such a change would _ the interest rate spread on the Risky Investment bond over Treasuries to _______ .

Which of the following explains the decrease in the annual rate of return on the Risky Investment bond?

1. The expected default rate on the Risky Investment bond has decreased.
2. The expected default rate on the Treasury bond has increased.
3. The expected default rate on the Treasury bond has decreased.
4. The expected default rate on the Risky Investment bond has increased.

a. The risk premium on a risky investment is equal to the total return on a risky investment less the return on the risk free asset. The risky asset here gives an annual return of 7.1% while the risk free rate is 1.3%. So, the risk premium on the risky asset for additional risk is,

7.1 - 1.3 = 5.8%

b. A reduction in the annual return on the risky asset will decrease/reduce the interest rate spread which is equal to the difference between the return of the risky and risk free asset. The new spread will be equal to,

5.5 - 1.3 = 4.2%

c. The risk free rate is expected to be the same as no information is provided. Besides, a fall in annual rate of risky investment means that there is a reduction in the riskiness of such an investment and that would mean that there is a reduction in the default risk in turn leading to a reduction in compensation for default and the default rate.

The risk is made up of risk free + maturity risk + liquidity risk and default risk.