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 4% per year for each of the next two years and 3% 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 U.S. Treasury Default Risk Premium 0.60% 0.80% 1.05% 1.45% BTR Warehousing issues nine-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 7.37% 7.62% 8.17% 4.95% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? O A B8B-rated bond has a lower default risk premium as compared to a AAA-rated bond 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

Explanation / Answer

Answer ) Rate of return(nominal return) r = rf + IP + DRP + MRP + LP

Where, rf = real risk-free rate, IP = inflation premium (average rate of inflation), DRP = default risk premium, MRP = maturity risk premium, LP = liquidity premium

rf = 2.8% , IP = (2*4%+7*3%)/9 = 3.22%, DRP= 0.80% , MRP = 0.1(9-1) = 0.8% ,LP= 0.55%

r= 2.8%+3.22%+0.80%+0.8%+0.55% = 8.17% Option C.

Answer b)

Option B:

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