Calculating interest rates The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 8% per year for each of the next two years and 7% 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 Gauge Imports Inc.’s bonds is 0.55%. 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% Gauge Imports Inc. issues 12-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. 11.87% 11.32% 5.25% 12.42% 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 a AAA-rated bond will be lower than the yield on a AA-rated bond. A BBB-rated bond has a lower default risk premium as compared to a AAA-rated bond.
9. Calculating interest rates The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 8% per year for each of the next two years and 7% 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 Gauge Imports Inc.’s bonds is 0.55%. 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% Gauge Imports Inc. issues 12-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. 11.87% 11.32% 5.25% 12.42% 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 a AAA-rated bond will be lower than the yield on a AA-rated bond. A BBB-rated bond has a lower default risk premium as compared to a AAA-rated bond.
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