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%
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text: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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