Final answer:
The liquidity risk premium on Tom and Sue's Flowers, Inc.'s 20-year bonds is calculated by subtracting the sum of the real risk-free rate, inflation premium, default risk premium, and maturity risk premium from the bond's total yield, resulting in a liquidity risk premium of 0.75%.
Step-by-step explanation:
The student is asking how to calculate the liquidity risk premium on Tom and Sue's Flowers, Inc.'s 20-year bonds given information about the bond's yield, inflation premium, real risk-free rate, default risk premium, and the maturity risk premium. To find the liquidity risk premium, we need to first understand that the bond's yield is the sum of the real risk-free rate, inflation premium, default risk premium, maturity risk premium, and the liquidity risk premium.
Using the given numbers, the bond's yield is 9.10%, the expected inflation premium is 3.10%, the real risk-free rate is 3.50%, and the default risk premium is 0.50%. The maturity risk premium for a 20-year bond can be calculated as 0.45% + (20-10)*0.08% = 1.25% since the premium increases by 0.08% for each year beyond 10 years.
Now, we can compute the liquidity risk premium as follows:
Bond Yield = Real Risk-Free Rate + Inflation Premium + Default Risk Premium + Maturity Risk Premium + Liquidity Risk Premium
9.10% = 3.50% + 3.10% + 0.50% + 1.25% + Liquidity Risk Premium
Liquidity Risk Premium = 9.10% - (3.50% + 3.10% + 0.50% + 1.25%)
Liquidity Risk Premium = 0.75%
Therefore, the liquidity risk premium on Tom and Sue's Flowers, Inc.'s 20-year bonds is 0.75%, rounded to two decimal places.