Morgan Motors has three-year bonds that currently yield 8.25%. The real risk-fre

Question

Morgan Motors has three-year bonds that currently yield 8.25%. The real risk-free rate (r*) it 2.50% and is expected to remain constant. Inflation Is expected to be 3.0% per year for each of the next four years and 5.00% thereafter. The maturity risk premium (MRP) Is determined from the formula: 0.1(t - 1)%, where t is the security's maturity. The default risk and liquidity premiums on all of Morgan's bonds are equal What is the yield on a six-year bond issued by Morgan Motors ? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. 8.97% 8.69% 9.13% 9.22% 8.88%

Explanation / Answer

r = r* + IP + DRP + LP + MRP Where r = required return on a security 8.25% for 3yrs bond r* = real risk-free rate of interest =2.5% IP = inflation premium = 3% for 4 yrs & 5% thereafter = (3%*4+5%*2)/6=3.67% DRP = default risk premium LP = liquidity premium MRP = maturity risk premium =0.1*(t-1)%= 0.1*(6-1)%= 0.5% for 6Yr & 0.1*(3-1)%=0.2% for 3Yr Bond Using 3 Yr Bond data, find LP=DRP. 8.25% = 2.5%+3%+2LP+0.2% ie LP= (8.25%-5.7%)/2 = 1.28% SO For 6 Yr Bond, & using LP & DRP foudn above r = 2.5%+3.67%+2*1.28%+0.5% = 9.22%..................Ans

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