3. Calculating interest ratesThe 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 two 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 Smith and Carter Inc.’s bonds is 1.05%. 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% Smith and Carter Inc. issues 7-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.11.54% 10.94% 10.49% 5.25% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity. A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.

Yield of bond is the required rate of bond and it depends on the many factors liquidity, inflation…

Answered: he real risk-free rate (r*) is 2.8% and…

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter8: Analysis Of Risk And Return

Section: Chapter Questions

Problem 10P

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3. Calculating interest rates

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 two 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 Smith and Carter Inc.’s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

Rating	Default Risk Premium
U.S. Treasury	—
AAA	0.60%
AA	0.80%
A	1.05%
BBB	1.45%

Smith and Carter Inc. issues 7-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.

11.54%

10.94%

10.49%

5.25%

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

In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity.

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

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