The real risk-free (r*) is 2.8% and is expected to remain constant. Inflation is
ID: 2809738 • Letter: T
Question
The real risk-free (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next four years and 3% thereafter.
The maturity risk premium (MRP) is determined from the formula: 0.1(t-1)% where t is the security's marturity. The liquidity premium (LP) on all Moq Computer Corp's bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):
US Treasury -
AAA .60%
AA .80%
A 1.05%
BBB 1.45%
Moq Computer Corp. issues six-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross- product terms; if averaging is required, use the arithmetic average.
A) 8.32%
B) 5.15%
C) 7.77%
D) 8.82%
Based on your understaind of the determinants of interest rates, if everything else reamins the same, which of the following will be true?
A) AAA-rated bond has less default risk than a BB-rated bond
B) The yield on AAA-rated bond will be higher than the yield on a BB-rated bond.
Explanation / Answer
Nominal Yield = Real risk free rate + Inflation premium + Default risk premium + Maturity risk premium + Liquidity risk premium
For Moq Computer Corp bonds rated AA,
Real risk free rate = 2.8%
Default risk premium = 0.80%
Maturity risk premium - 0.1 * (6 - 1)% = 0.5%
Liquidity risk premium = 1.05%
Inflation premium for a 6 year bond will be average of inflation over 6 years = ((4% * 4) + (3% * 2))/6 = 3.67%
Nominal risk free rate = 2.8% + 3.67% + 1.05% + 0.80% + 0.50% = 8.82% (Option D)
Question2: True statement is AAA-rated bond has less default risk than a BB-rated bond
Higher the rating on bond, lower will be its risk of default. Lower risk implies lower return (or yield) and hence AAA- rated bond will have lower yield than on a BB-rated bond. SO statement B is incorrect.
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