Essentials Of Investments
Essentials Of Investments
11th Edition
ISBN: 9781260013924
Author: Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher: Mcgraw-hill Education,
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Calculating interest rates

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 five 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 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
AAA 0.60%
AA 0.80%
A 1.05%
BBB 1.45%

Q1. Smith and Carter Inc. issues fifteen-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.

a. 12.33%

b. 13.38%

c. 6.05%

d. 11.98%

Q2. Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?

Option a. A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.

Option b. The yield on an AAA-rated bond will be lower than the yield on an AA-rated bond.

 

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