Question

In: Finance

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 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.

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.


Related Solutions

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected...
The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next three years and 3% thereafter. 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 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): AAA- 0.60% AA-...
The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected...
The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 7% per year for each of the next three years and 6% thereafter. 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 Sacramone Products Co.’s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Rating Default Risk...
The real risk-free rate, r*, is 2.6%. Inflation is expected to average 2.25% per year for the next 4 years, after which time it is expected to average 3.75%, forever.
The real risk-free rate, r*, is 2.6%. Inflation is expected to average 2.25% per year for the next 4 years, after which time it is expected to average 3.75%, forever. An 8-year corporate bond Issued by the Vondrell Corporation will yield 9.5%, which includes a maturity risk premium of 0.20 x (t – 1)%, where t is the bond maturity in years. Assume there is no liquidity premium on Vondrell bonds. What is the yield spread between Vondrell and an...
Assume that the real risk-free rate, r*, is 2% and that inflation is expected to be 7% in Year 1, 6% in Year 2, and 3% thereafter.
Problem 4-19Maturity Risk PremiumsAssume that the real risk-free rate, r*, is 2% and that inflation is expected to be 7% in Year 1, 6% in Year 2, and 3% thereafter. Assume also that all Treasury securities are highly liquid and free of default risk. If 2-year and 5-year Treasury notes both yield 10%, what is the difference in the maturity risk premiums (MRPs) on the two notes; that is, what is MRP5minus MRP2? Round your answer to two decimal places.%
The real risk-free rate is 3.3%. Inflation is expected to be 2.3% this year, 3.85% next...
The real risk-free rate is 3.3%. Inflation is expected to be 2.3% this year, 3.85% next year, and 2.05% thereafter. The maturity risk premium is estimated to be 0.05 × (t - 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? Do not round intermediate calculations. Round your answer to two decimal places . %
The real risk-free rate is 2.45%. Inflation is expected to be 3.45% this year, 4.85% next...
The real risk-free rate is 2.45%. Inflation is expected to be 3.45% this year, 4.85% next year, and 2.7% thereafter. The maturity risk premium is estimated to be 0.05 × (t - 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? Do not round intermediate calculations. Round your answer to two decimal places.
The real risk-free rate is 2.55%. Inflation is expected to be 3.55% this year, 4.45% next...
The real risk-free rate is 2.55%. Inflation is expected to be 3.55% this year, 4.45% next year, and 2.6% thereafter. The maturity risk premium is estimated to be 0.05 × (t - 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? Do not round intermediate calculations. Round your answer to two decimal places.   %
The real risk-free rate is 1.75%. Inflation is expected to be2.75% this year, 4.45% next...
The real risk-free rate is 1.75%. Inflation is expected to be 2.75% this year, 4.45% next year, and 2.1% thereafter. The maturity risk premium is estimated to be 0.05 × (t - 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? Do not round intermediate calculations. Round your answer to two decimal places.
The real risk-free rate is 1.95%. Inflation is expected to be2.95% this year, 4.85% next...
The real risk-free rate is 1.95%. Inflation is expected to be 2.95% this year, 4.85% next year, and 2.3% thereafter. The maturity risk premium is estimated to be 0.05 × (t - 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? Do not round intermediate calculations. Round your answer to two decimal places.
The real risk-free rate is 1.95%. Inflation is expected to be2.95% this year, 4.65% next...
The real risk-free rate is 1.95%. Inflation is expected to be 2.95% this year, 4.65% next year, and 2.3% thereafter. The maturity risk premium is estimated to be 0.05 × (t - 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? Do not round intermediate calculations. Round your answer to two decimal places.
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT