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 4% per year for each of the next three years and 3% 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 Sacramone Products Co.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP) Rating U.S. Treasury Default Risk Premium 0.60% 0.80% 1.05% 1.45% Sacramone Products Co. issues 14-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 7.36% 5.45% O 8.66% 8.11% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? O Higher inflation expectations increase the nominal interest rate demanded by investors O A BBB-rated bond has a lower default risk premium as compared to a AAA-rated bond

Explanation / Answer

Nominal Yield = Real risk free rate + Inflation premium + Default risk premium + Maturity risk premium + Liquidity risk premium

For Sacromone Products bonds rated AA,

Real risk free rate = 2.8%

Default risk premium = 0.80%

Maturity risk premium - 0.1 * (14 - 1)% = 1.3%

Liquidity risk premium = 0.55%

Inflation premium for a 14 year bond will be average of inflation over 14 years = ((4% * 3) + (3% * 11))/14 = 3.21%

Nominal risk free rate = 2.8% + 3.21% + 1.3% + 0.80% + 0.55% = 8.66% (Option C)

Question2: True statement is Higher inflation expectations increase the nominal interest rate demanded by investors

Higher the rating on bond, lower will be its risk of default. So, BBB-rated bond will have a higher default risk premium compared to that of bond with AAA rating. So statement B is incorrect.

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