4. Calculating interest rates Aa Aa The real risk-free rate (r*) is 2.8% and is

Question

4. Calculating interest rates Aa Aa 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 five years and 790 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 Harrington Horticulture Co.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Default Risk Premium Rating U.S. Treasury 0.60% 0.80% 1.05% 1.45% Harrington Horticulture Co. issues 15-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 12.33% 11.48% 12.88% 5.55% ? ? Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? O Higher inflation expectations increase the nominal interest rate demanded by investors O The yield on U.S. Treasury securities always remains static.

Explanation / Answer

1) Bond yield = r* + IP + MRP + LP + DRP

r* = 2.8%

IP (inflation premium) = Average of inflation over 15 years = (8% x 5 + 7% x 10) / 15 = 7.3333333% or 7.33%

MRP = 0.1 x (t - 1)% = 0.1 x (15 - 1)% = 1.4%

LP = 0.55%

DRP = AA rate bonds = 0.80%

Bond yield = 2.8% + 7.33% + 1.4% + 0.55% + 0.80% = 12.88%

2) Higher inflation expectations increase the nominal interest rate demanded by investors.

Yield on US treasury securities is not always static. It changes according to the time horizon of the investors.

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