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 8% per year for each of the next four years and 7% 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 Dare Satellite Corp.'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% Dare Satellite Corp. issues 10-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. 11.55% ? 12.45% ? 5.05% o 11,90% Based on your underständing of the determinants of interest rates, if everything else remains the same, which of the following will be true? O 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 wil be lower than the yield on a AA-rated bond.

Explanation / Answer

Yield on bond = r*+IP+MRP+LP+DRP

= 2.8%+[(8%*4+7%*6)/10] + [0.1(10-1)%] + 0.55% + 0.80%

= 2.8% + 7.4% + 0.9% + 0.55% + 0.80%

= 12.45%

Ans B

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

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