On the first day of your summer? internship, you\'ve been assigned to work with

Question

On the first day of your summer? internship, you've been assigned to work with the Chief Financial Officer? (CFO) of SanBlas Jewels Inc. Not knowing how well trained you? are, the CFO has decided to test your understanding of interest rates.? Specifically, she asks you to provide a reasonable estimate of the nominal interest rate for a new issue of? Aaa-rated bonds to be offered by SanBlas Jewels Inc. The final format that the chief financial officer of SanBlas Jewels has requested is that of equation? (2-1) in the? text: Nominal interest rate= real risk-free interest rate+inflation premium+default-risk premium +maturity-risk premium+liquidity-risk premium.

Some? agreed-upon procedures related to generating estimates for key variables in equation? (2-1) follow. a. The current? 3-month Treasury bill rate is 2.85?percent, the? 30-year Treasury bond rate is 5.35 ?percent, the? 30-year Aaa-rated corporate bond rate is 6.88 ?percent, and the inflation rate is 2.38 percent.

b. The real? risk-free rate of interest is the difference between the calculated average yield on? 3-month Treasury bills and the inflation rate

. c. The? default-risk premium is estimated by the difference between the average yields on? Aaa-rated bonds and? 30-year Treasury bonds.

d. The? maturity-risk premium is estimated by the difference between the average yields on? 30-year Treasury bonds and? 3-month Treasury bills.

e. SanBlas? Jewels' bonds will be traded on the New York Bond? Exchange, so the? liquidity-risk premium will be slight. It will be greater than? zero, however, because the secondary market for the? firm's bonds is more uncertain than that of some other jewelry sellers. It is estimated at 7 basis points. A basis point is one? one-hundredth of 1 percent. Now place your output into the format of equation? (2-1) so that the nominal interest rate can be estimated and the size of each variable can also be inspected for reasonableness and discussion with the CFO.

Explanation / Answer

Solution

Calculation of the Real Risk Free Interest Rate:

REAL risk free interest rate = 3-month Treasury bill rate –inflation rate

3-month Treasury bill rate is 2.85%

Inflation rate is 2.38%

Real?risk-free rate of interest= 2.85%-2.38%

The Real Risk Free Interest Rate is 0.47%

Therefore, the Real Risk Free Interest Rate is0.47%

Related Questions

Navigate

• Browse (All)
• Browse O
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.