The real risk-free rate (r.) is 2.8% and is expeced to remain constant. Inflatio

Question

The real risk-free rate (r.) is 2.8% and is expeced to remain constant. Inflation is expected to be 5% per year for each of the next fve years and 4% thereafter The maturty risk premium (MRP) is determined from the formula: 0.1(-1)%, where t is the security's maturity. The Iquidity premium (LP) on all Lukin Holdings Inc's bonds is 1.05%. The folowing table showhe arrent re ationship between bond ratings and de'aulkt risk premiums (DRP) Rating Default Risk Premium U.S. Treasury 0.60% 0.80% 1.05% 1.45% Llukin Holdings Inc. Issues six-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. Q 9.48% o 9.98% 8.93% Besed on your uncerstanding of the determinants of interest rates, if everything eise remains the same, which of the following will be true? O In theory, the yieid on a bond with a longer maturity will be higher than the yield on a bond with a shorte O The yield on U.S. Treasury securities always remains static 0 2 3 4 aWE

Explanation / Answer

The inflation premium = (5*5+4)/6 = 4.83 MP = 0.1*(6-1) = 0.50 LP 1.05 DRP 0.80 Real risk free rate 2.80 Yield on the bonds is the sum of the above = 9.98% TRUE STATEMENT *In theory, the yield on a bond………………………..

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