The risk free rate of interest is 2.5%. Inflation is expected to be 1.6% this ye

Question

The risk free rate of interest is 2.5%. Inflation is expected to be 1.6% this year, 2% next year and the following years. Assume the maturity risk premium is calculated to be .15 x (t - l)%, default premium is fixed at 1% and liquidity premium is fixed at 1%. What is the yield on a 5 year bond A 9 year bond Currently, the price of energy products as fallen in the past year by 40%. According to our class discussions, could this security described above be a current Russian (Russia is heavily dependent on Oil) bond Explain why or why not. Think in terms of how healthy the economy is and risk.

Explanation / Answer

Risk free rate = 2.5%

Inflation rate after year 3 = 3%

Maturity risk premium = .15 × (t – 1) %

Default risk premium = 1%

Liquidity premium = 1%

a.

Tenure (t) = 5 year

Yield of the bond is calculated below using following formula:

Interest rate= RRF+IP+DRP+LP+MRP

                  = 2.5% +3% + [.15 × (5 - 1)] + 1% +1%

                   = 7.5% +0.6%

                   = 8.1%

Hence, yield of the bond is 8.1%

b.

Tenure (t) = 9 year

Yield of the bond is calculated below using following formula:

Interest rate= RRF+IP+DRP+LP+MRP

                  = 2.5% +3% + [.15 × (9 - 1)] + 1% +1%

                   = 7.5% +1.2%

                   = 8.7%

Hence, yield of the bond is 8.7%

c.

Since energy price decrease from past by 40% due to bad economy situation in Russia. Also Russia economy depend on production and export of oil and gas. This will directly affect the yield of the bond. Default risk premium will be high because there is chance of default is high. Inflation in the economy will increase. Liquidity premium of the yield of the bond will be high

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