Determinants of Interest Rate for Individual Securities You are considering an i

Question

Determinants of Interest Rate for Individual Securities You are considering an investment in 30-year bonds issued by a corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 3.90 percent. Your broker has determined the following information about economic activity and the corporation bonds:

Real interest rate = 3.45%
Default risk premium = 3.65%
Liquidity risk premium = 1.65%
Maturity risk premium = 3.40%

What is the inflation premium? What is the fair interest rate on the corporation's 30-year bonds?

.45% and 2.52%, respectively

.45% and 12.60%, respectively

.45% and 12.15%, respectively

3.90% and 16.05%, respectively

Explanation / Answer

Nominal interest rate = real interest rate + Inflation

3.90 = 3.45 + inflation

So, inflation = 3.90- 3.45 = 0.45%

Fair rate of interest = real interest rate + inflation + default risk premium + liquidity risk premium + maturity risk premium

= 3.45 + 0.45+ 3.65 + 1.65+ 3.4

=12.60%

So, Option B is the most suitable option

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