Assignment 06-Interest Rates Due on Tomorrow at 11:59 PM PST Attempts: Keep the

Question

Assignment 06-Interest Rates Due on Tomorrow at 11:59 PM PST Attempts: Keep the Highest: /2 4. Calculating interest rates Aa Aa The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 3% per year for each of the next three years and 2% 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 Smith and Carter Inc.'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%

Explanation / Answer

r= r* + Inflation premium + Default risk premium + Liquidity premium + Maturity risk premium

IP = 3%*3 + 2%*6 / 9 = 2.3333%

DRP = 0.8%

LP = 1.05%

MRP = 0.1* (9-1)% = 0.8%

Hence r = 2.8+ 2.33+ 0.8+ 1.05+ 0.8

Yield = 7.78%

2. A AAA rated bond has less default risk than a BB rated bond

(Yields change depending on investors' expected rate of return,and , macroeconomic conditions. Hence the yield on US treasury securities does not remain constant. HIgher the period of holding, higher is the risk. A AAA rated bond will have lower default risk. AAA rated bonds are considered lower risk for that purpose since they are rated as per the credibility of the issuer.)

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