Determinants of Interest Rate for Individual Securities You are considering an i

Question

Determinants of Interest Rate for Individual Securities You are considering an investment in 30-year bonds issued by a corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 3.90 percent. Your broker has determined the following information about economic activity and the corporation bonds:

Real interest rate = 3.20%
Default risk premium = 3.15%
Liquidity risk premium = 1.40%
Maturity risk premium = 2.90%

What is the inflation premium? What is the fair interest rate on the corporation's 30-year bonds?

Explanation / Answer

The T Bills are short term risk free securities. The Rate of interest on T Bills comprises of Real Risk Free rate and Expected Inflation Premium.

Tus we have,

Yield on T Bills = Real Risk Free rate + Expected Inflation Premium

3.9 = 3.2 + Expected Inflation Premium

Thus inflation premium = 3.9 - 3.2 = 0.7%

Now we need to calculate fair interest rate on the corporation's 30-year bonds which is equal to :

Real interest rate + Default risk premium + Liquidity risk premium + Maturity risk premium + inflation premium

= 3.2 + 3.15 + 1.4 + 2.9 + 0.7 = 11.35%

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