The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 5% per year for each of the next two years and 4% thereafter.

3. Calculating interest rates

The maturity risk premium (MRP) is determined from the formula: 0.1(t – 1)%, where t is the security’s maturity. The liquidity premium (LP) on all Global Satellite Corp.’s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

RatingDefault Risk PremiumU.S. Treasury—AAA0.60%AA0.80%A1.05%BBB1.45%

Global Satellite Corp. issues nine-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average.

9.17%

4.95%

8.37%

8.62%

Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?

The yield on an AAA-rated bond will be lower than the yield on an AA-rated bond.

A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.

Solutions

Expert Solution

Solution

ANSWER A:

r = r* + IP + DRP + LP + MRP

R = yeild r* = real risk free rate of interest IP= inflation Premium DRP= default risk premium LP= liquidity premium MRP= market risk premium

r* = 2.8%

IP₉ = [ ( 5% *2 ) + (4% * 7)] / 9 years = 4.22%

MRP₉ = 0.1 (9-1)% = 0.8%

r = 2.8 + 4.22 + 0.8 + 0.55 + 0.8

r = 9.17%

ANSWER B:-The yield on an AAA-rated bond will be lower than the yield on an AA-rated bond.

jeff jeffy answered 2 years ago

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