The formula as per Schweser is : risk free rate + inflation premium + maturity premium + default premium + illiquidity premium + tax premium. This question also included call risk spread, which was added in the answer. Is it a part of default premium cause it’s not in the formula given in Schweser.
Well I guess Schweser isn’t as exhaustive. Call risk is a distinct risk which is not incorporated in the ones you listed. So make sure to add it in case of a callable bond.
Thank you! So I should only add it if it’s a callable bond? And not otherwise?
Yes call risk premium only if it’s a callable bond or MBS (which works similarly to callable bond).
I think MBS prepayment/extension is a distinct risk different from call risk. Call risk is more applicable to bonds.
Yeah, the prepayment risk would ideally be defined distinctly from the call risk.
I would approach these questions by setting up the basic risks so real rfr + inflation + adjusting to maturity + adjusting for credit risk and then look at the specifics. What else will have an impact on the price of the bond?
If there is a call feature for the issuer which is a negative feature for me as the investor then it needs an adjustment downwards in price e.g. a risk premium for that
If it is a very illiquid bond, then I need to adjust for that also etc.