3 Celculating interest rates As Aa The real risk free rate m

3. Celculating interest rates As Aa The real risk free rate (m is 2.8% and is expected to remain onstant. Inflation is expected to be 7% per year for each of the next three years and 6% wseafter. 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 Moq Computer arp.\'s bonds is 0.55%. The followi relationship between bond ratings and default risk premiums (DRP): ng table shows the current Rating U.S. Treasury Default Risk Premium 0.60% 0.80% 1.05% 1.45% Moq Computer Corp, issues seven-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required,Lge the arithmetic average. o 4.75% ? 10.58% ? 10.63% O 11.18% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?

Solution

Question 1

Nominal yield on a bond is mathematically represented as:

Nominal yield = Real risk free rate + Inflation Premium + Maturity Risk Premium + Default Risk Premium + Liquidity Premium

Inflation Premium = (7% * 3 + 6% * 4)/7 = 6.43%

Maturity Risk premium for 7 Years = 0.1 * (7 - 1)% = 0.60%

Nominal Yield = 2.8% + 6.43% + 0.60% + 0.80% + 0.55% = 11.18% --> Answer

Question 2

A AAA-rated bond has less default risk. This is visible from the fact that lower default risk leads to lower default risk premium for AAA, compared to BB-rated bond.

Statement 2 is incorrect as default risk premium is higher for BBB-rated bond, compared to that of AAA-rated bond.