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 6% per year for each of the next five years and 5% 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 BTR warehousing'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% BTR Warehousing issues 11-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. O 10.05% 9.60% 10.60% 5.15% 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. O The yield on a AAA-rated bond will be lower than the yield on a AA-rated bond

Explanation / Answer

c.10.60%.

yield = risk free rate + inflation + maturity risk premium + liquidity premium + default risk premium

here,

risk free rate = 2.8%

inflation =( 6% * 5 years + 5% * 6years)/11 years............(since bond is for 11 years).

=>(30 + 30)/11

=>5.45%.

maturity risk premium = 0.1 *(11 - 1)%

=>0.10* (10)%

=>1%.

liquidity risk premium = 0.55%.

defalult risk premium = 0.80%..........(since bonds are AA rate)

now,

yield on 11 year bond = 2.8% + 5.45% +1% + 0.55% + 0.80%

=>2.8% + 5.45% +1% +0.55% + 0.80%

=>10.60%.

2nd part

the following statement is true.

The yield on AAA rated bond will be lower than yield on AA rated bond.

(this is because, other things being equal , the default risk premium on AAA bonds is less than that of AA rated bonds).

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