1) You are given the following information: • r* = 1.5% • Investors expect infla

Question

1) You are given the following information:

• r* = 1.5%

• Investors expect inflation to average 3% per year into the foreseeable future

• The MRP on 200 year bonds = 2% • The LP on U.S. and Yubaba Inc. bonds = 0

• The interest rate on a 20 year loan to Yubaba Inc. is 1.25 times the rate on a 20 year loan to the U.S. government

a) What is the interest rate on a 1 year loan to the U.S. government?

b) What is the interest rate on a 20 year loan to the U.S. government?

c) What is the DRP on a 20 year loan to Yubaba Inc.?

Explanation / Answer

Solution:

a. To find the interest rate on a 1 year loan to the U.S. government, we use the formula

r = r* + IP + MRP + LP + DRP

r = 1.5% + 3% + 0 + 0 0

r = 4.5%

b. To find the interest rate on a 20 year loan to the U.S. government, we know that the interest on 0

r = r* + IP + MRP + LP + DRP

r = 1.5% + 3% + 2% + 0 + 0

r = 6.5%

c. Since interest rate on a 20 year loan to Yubba is 1.25 times the rate on a 20 year loan to the U.S. government i.e. 6.5% (1.25) = 8.125%. Now, we use the formula

r = r* + IP + MRP + LP + DRP

8.125% = 1.5% + 3% + 2% + 0 + DRP

DRP = 1.625%

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