Back to Assignment Attempts: Keep the Highest: 12 4. Calculating interest rates

Question

Back to Assignment Attempts: Keep the Highest: 12 4. Calculating interest rates Aa The real risk-free rate-) is 2.8% and is expected to reman onstant. Inflation is expected to be 7% per year for each of the next four years and 6% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(-1)%, where t is the security's matur ty The liquidity premium LP on all Pellegrini Southern Inc.'s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRF) U.S. Treasury 0.30% I 1.05% Pellegrin' Southern Inc. issues eght-year, AA-rated bonds. What is the yield on one of these bonds? Disregar cross-product terms; that is, if aweraging is required, use the arithmetic avera 10.80% 0 11.85% 5.35% 11.15% Based on your understanding of the determinants of nterest rates, f everythng eise remains the same, which of the O A AAA-rated bond has less default risk than a Ba-rated bond. O The yield on a AA4-rated bond will be higher than the yied on a B-roted bond

Explanation / Answer

1)

Maturity Risk Premium = 0.1*(8-1) = 0.7%

Liquidity Premium = 1.05%

Default Risk Premium = 0.8% (As per AA-bond)

Inflation Risk Premium = 7% for year 1-4 and 6% for Year 5-8

Risk Free Rate = 2.8 %

Yield (for Next 4 years) =  Risk Free Rate + Maturity Risk Premium + Liquidity Premium + Default Risk Premium + Inflation Risk Premium = 2.8+0.7+1.05 +0.8+7 = 12.35%

Yield (for Last for Years)  = Risk Free Rate + Maturity Risk Premium + Liquidity Premium + Default Risk Premium + Inflation Risk Premium = 2.8+0.7+1.05 +0.8+6 = 11.35%

Yield = arithmatic average = 0.5*(12.35+11.35) = 11.85%

2)

Answers is

A AAA-rated bond has less default risk than a BB-rated bond

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