Hi
Refer to Schweser notes, Reading #12, question #11:
Solution:
From my understanding, the annual payment is fixed and increased annually by a fixed rate. Thus, shouldn’t the annual payments be discounted with risk free rate? Why is the risk premium included in the calculation?
Thanks.
Yes, the payments are fixed and increase annually, but if they were risk free, then the risk premium would be 0.
In the big picture of things, discounting cash flows with risk free rate assumes zero market beta: i.e. your investments are not affected by capital markets. In practice pension plans ARE exposed to capital markets and risk free rates are by default inappropriate.
IMO the question is somewhat ambiguous and it is not clear why risk free rate should be avoided, but in the exam this will be one major caveat to bear in mind.
Perhaps the clue is in that g=5% while r=3% so the asset must be invested in a higher yield investment at the very least.