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's 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

step1:

find market risk premium pf 4-year bonds

MRP = 0.1% (4-1) = 0.3%

step2:

finf inflation premum on 4-year bonds

=>

7.4% = 2.7% + 0.3% + 0.9% + IP4

=>
IP4 = 3.5%

step3:

calculate 7-year inflation premium

IP7 = (3.5% * 4 + 5% *3]/7 = 4.14%

step5:
MRP on 7 -year bonds = 0.1% * (7-1) = 0.6%

yield on 7-year bonds

= 2.7% + 0.6% + 0.9% + 4.14%

= 8.34% ................................ans

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