Uncle Sal, the family accountant is home from his failed attempt at striking it rich in Vegas and wants to make up for it by selling a few securities on the side. He has an offer that he is pitching to an older lady he calls "Granny." The offer is for a 30 year bond issued by an insurance company and paying 7% annual interest. Sal will get a commission of 0.25% from the issuer of the bond. Granny has the $100,000.00 in a money market account earning 0.28% interest per year. Granny expects the inflation rate to average around 2.5% each year. She thinks the bond is risky and would require a default risk premium of about 3%. She sees that treasury bonds of equal duration (30 years) are selling for about 5% in the current economy. Question: Based on her understanding of the risks involved, is the investment appropriate for her?
The offered investment has a return rate of 7%*(1-0.25%) = 6.98%
However, Granny's expected return rate = ...
Simple computation and a few words to explain it. A default risk premium of about 3% are examined.