Drongo Corporation\'s 4-year bonds currently yield 7.4 percent. The real risk-fr

Question

Drongo Corporation's 4-year bonds currently yield 7.4 percent.

The real risk-free rate of interest, r*, is 2.7 percent and is assumed to be constant.

The maturity risk premium (MRP) is estimated to be 0.1%(t - 1), where t is equal to the time to maturity.

The default risk and liquidity premiums for this company bonds total 0.9 percent and are believed to be the same for all bonds issued by this company.

If the average inflation rate is expected to be 5 percent for years 5, 6, and 7, what is the yield on a 7-year bond for Drongo Corporation?

Explanation / Answer

Expected interest rates   

The MRP for the 4-year bond is 0.1%(4 - 1) = 0.3%. Find the 4-year IP as 7.4% = 2.7% + 0.3% + 0.9% + IP4, or IP4 = 3.5%. Calculate the 7-year IP as [3.5%(4) + 5%(3)]/7 = 4.14%. The MRP for the 7-year bond is 0.1%(7 - 1) = 0.6%. Finally, the yield on the 7-year bond is 2.7% + 0.6% + 0.9% + 4.14% = 8.34%.

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