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 two 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 Nitreca Chemicals Inc.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Nitreca Chemicals Inc. issues nine-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. 11.37% 12.17% 11.62% 4.95% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? The yield on a AAA-rated bond will be higher than the yield on a BB-rated bond. In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity.

Explanation / Answer

ANSWER A:

r = r* + IP + DRP + LP + MRP

R = yeild r* = real risk free rate of interest IP= inflation Premium DRP= default risk premium LP= liquidity premium MRP= market risk premium

r* = 2.8%

IP9 = [ ( 8% *2 ) + (7% * 7)] / 9 years = 7.22%

MRP9 = 0.1 (9-1)% = 0.8%

r = 2.8 + 7.22 + 0.8 + 0.55 + 0.8

r = 12.17%

ANSWER B:-IN THEORY YIELD ON BONDS WITH LONGER MATURITY WILL BE HIGHER THAN YIELD ON BONDS WITH SHORTER MATURITY

A normal yield curve (pictured here) is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time.

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