3. Calculating interest ratesThe real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 3% per year for each of the next five years and 2%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 allDare Satellite Corp.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):RatingU.S. TreasuryAAAAAABBB6.91%4.75%Dare Satellite Corp. issues seven-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging isrequired, use the arithmetic average.6.86%Default Risk PremiumO 7.46%0.60%0.80%1.05%1.45%Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?O An AAA-rated bond has less default risk than a BB-rated bond.O A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.

Yield rate refers to the return that is to be earned over investments that are expressed in the form…

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 3% per year for each of the next five years and 2% 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 Dare Satellite Corp.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Rating U.S. Treasury AAA AA A BBB Default Risk Premium 0.60% 0.80% 1.05% 1.45%

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 3% per year for each of the next five years and 2% 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 Dare Satellite Corp.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Rating U.S. Treasury AAA AA A BBB Default Risk Premium 0.60% 0.80% 1.05% 1.45%

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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Concept explainers

Treasury Market

On-the-run securities are the most recently issued securities in the market depth and are therefore traded at some premium. The off-the-run securities are the ones issued just before the most recent ones. The on-the-run securities have a lower yield to the investor than the off-the-run securities.

Question

3. Calculating interest rates
The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 3% per year for each of the next five years and 2%
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
Dare Satellite Corp.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):
Rating
U.S. Treasury
AAA
AA
A
BBB
6.91%
4.75%
Dare Satellite 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, use the arithmetic average.
6.86%
Default Risk Premium
O 7.46%
0.60%
0.80%
1.05%
1.45%
Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?
O An AAA-rated bond has less default risk than a BB-rated bond.
O A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.

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