4. Calculating interest rates Aa Aa The real risk-free rate (r*) is 2.8% and is

Question

4. Calculating interest rates Aa Aa The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 5% per year for each of the next two years and 4% 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 Berth Construction Inc.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP) Rating Default Risk Premium U.S. Treasury 0.60% 0.80% 1.05% 1.45% Berth Construction Inc. issues 13-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. 8.95% 8.30% 5.35% 9.50% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? O In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity The yield on U.S. Treasury securities always remains static

Explanation / Answer

average inflation = 5*2 + 4*11/13 = 4.1538%

yield = 2.8% + 4.1538% + 0.1*12% + 0.55% + 0.8% = 9.50%

Option A is correct

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