The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflati
ID: 2737385 • Letter: T
Question
The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 7% per year for each of the next two years and 6% 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 Rink Machine Co.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Rink Machine Co. issues 10-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. 5.05% 11.25% 10.70% 10.35% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? The yield on a AAA-rated bond will be lower than the yield on a AA-rated bond. The yield on U.S. Treasury securities always remains static.Explanation / Answer
Answer: 11.25%
IP10 = [(2 * 7%) + (8 * 6%)]/10 = 6.2%
MRP15 = 0.1 * (t - 1)%
= 0.1 * (10 - 1)% = 0.9%
rk = r* + IP + DRP+ LP + MRP
= 2.8% + 6.2% + 0.80% + 0.55% + 0.9% =11.25%
Answer: The yield on AAA-rated bonds will be lower than yield on AA-rated bonds. The higher the risk, the higher will be the return. Because you are taking on more risk over the life of the security, you will be compensated for a longer time period, thus having a higher yield rate.
US. Treasury securities, backed by the full faith of the US. government, are considered to be risk-free in an inflation-free world. However, this does not mean that the yield on US. Treasury securities remains static. Yields change depending on investors' expected rate of return, time preference of consumption, macroeconomic conditions, and several other technical factors.
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