The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflati

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 four 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 Tahoe Hydroponics's bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Tahoe Hydroponics issues seven-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. 11.82% 10.77% 5.25% 11.22% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? A BBB-rated bond has a lower default risk premium as compared to a AAA-rated bond. In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity.

Explanation / Answer

Yield = real risk free rate + Average Inflation premium + MRP +LP + Default risk premium

Yeild = 2.8% + (7%+7%+7%+7% + 6%+6%+6%)/7 + 0.1*(7-1)% + 1.05% + 0.80%

Yeild = 11.82%

Answer

Yeild = 11.82%

2)

In theory, the yield on a bond with long term maturity will be higher than the yield on bond with shorter maturity

Note : The above statement is true because as Long term would increase the time of maturity which lead increase in maturity risk premium and therefore it would increase Yield , so in theory yield on a bond with long term maturity will be higher than the yield on bond with shorter maturity

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