9. Calculating interest rates Aa Aa The real risk-free rate (m) is 2.8% and is e

Question

9. Calculating interest rates Aa Aa The real risk-free rate (m) is 2.8% and is expected to remain constant. Inflation is expected to be 6% per year for each of the next four 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 National Transmissions Corp. 's bonds is 1.05%. 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% National Transmissions Corp. 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. 10.82% 10.32% 9.77% 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? O The yield on U.S. Treasury securities always remains static. Higher inflation expectations increase the nominal interest rate demanded by investors.

Explanation / Answer

Nominal Yield on a bond is mathematically represented as:

Nominal Yield = Real risk free rate + Default Risk Premium + Liquidity Risk Premium + Inflation Risk + Maturity Risk Premium

Inflation risk premium will be the average of inflation rates for 6 years = (6% + 6% + 6% + 6% + 5% + 5%)/6 = 34%/6 = 5.67%

Nominal Yield = 2.8% + 0.80% + 1.05% + 5.67% + 0.1 * (6 - 1)% = 10.82%(Answer)

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Question 2: Answer is Option 2

Option 1 is false. The yield on treasury securities also change depending upon the inflation risk or maturity risk premium.

Option 2 is true. Higher inflation expectations will increase the nominal interest rate demanded by investors. You can confirm this from the nominal yield formula given above.

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