2-12. (Interest rate determination) You\'re looking at some corporate bonds issu

Question

2-12. (Interest rate determination) You're looking at some corporate bonds issued by Ford, and you are trying to determine what the nominal interest rate should be on them. You have determined that the real risk-free interest rate is 30%, and this rate is expected to continue on into the future without any change. In addition, infla- tion is expected to be constant over the future at a rate of 3.0%. The default-risk pre- lrnium is also expected to remain constant at a rate of 1.5%, and the liquidity-risk

Explanation / Answer

r = Real risk-free interest rate + Inflation premium + Default risk premium + Liquidity premium + Maturity premium

Inflation premium is the average of all years. Since it is same every year, the average annual IP will be 3% every year.

r 0-1 = 3%+ 3%+ 1.5%+ 0.02%+ 0.07% = 7.59%

r 1-2 = 3%+ 3%+ 1.5%+ 0.02%+0.35% = 7.87%

r 2-3 = 3%+ 3%+ 1.5%+ 0.02%+0.7%= 8.22%

r 3-4 = 3%+ 3%+ 1.5%+ 0.02%+1% = 8.52%

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