Chapter 6 question 2 You are considering an investment in 30-year bonds issued b

Question

Chapter 6 question 2

You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 1.35 percent. Your broker has determined the following information about economic activity and Moore Corporation bonds:

    

   

  

  

What is the fair interest rate on Moore Corporation 30-year bonds? (Round your answer to 2 decimal places.)

  

  Real risk-free rate = 0.65%   Default risk premium = 1.25%   Liquidity risk premium = 0.70%   Maturity risk premium = 1.85%

Explanation / Answer

Part A)

The inflation premium can be calculated with the use of following formula:

Inflation Premium = Treasury Bill Interest Rate (i) - Real Interest Rate (RIR)

_________

Using the values provided in the question, we get,

Inflation Premium = 1.35 - .65 = .70%

_________

Part B)

The fair interest rate can be calculated with the use of following formula:

Fair Interest Rate = Expected Inflation Premium + Real Risk-Free Rate + Default Risk Premium + Liquidity Risk Premium + Maturity Risk Premium

_________

Using the information provided in the question and the value of expected inflation premium as calculated in Part A, we get,

Fair Interest Rate = .70 + .65 + 1.25 + .70 + 1.85 = 5.15%

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