1) Inflation Rate Risk

2) TVM
(Time Component of Risk)
at T=0,
BOC=2.5%
Telus=2.5%
YTM(yield to maturity)=sum of 1),2),3)
3) Default Risk = 0/2.5 for BoC (no default risk premium associated as most likely
not gonna default)
Default Risk for Telus = 7.5/10 (since total interest rate is 10, default risk is 7.5% >10-2.5)
You can think of the BoC rate as the minimum that someone will accept for the end
of a 5 year term.
Why would you invest at the Royal Bank of Canada when it has positive default risk
when you can invest in BoC default risk free?
Note: you want your borrowing costs as low as possible, but not TOO low that no
one will want to led you money. In this example, telus determined their interest rate
is 10% and therefore, that will be what their COUPON RATE is. Coupon rates dont
change unless the company defaults.
The yield to maturity, however, does change with time.
I.e. at T=2
Lets assume that EITHER AND Interest rate risk and TVM has increased a combined
one percent to 3.5%
The time components of risk change with the BoCs objectives (stimulate economy,
slow economy).