Assume that the real risk-free rate of return is 3% and that the expected inflation premium is 5%. If the risk premium incorporates default risk, liquidity risk, and any maturity premium, an observed (nominal) interest rate of 12% implies that the risk premium is closest to:
A is correct. The nominal rate = real risk-free rate of return + an inflation premium + risk premiums (default, liquidity, maturity preference). In this case,12 = 3 + 5 + X. Solve for X. X = 4.