Question
3. Calculating interest rates The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 6% per year
3. Calculating interest rates The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 6% per year for each of the next four years and 5% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(t 1)%, where t is the securitys maturity. The liquidity premium (LP) on all Global Satellite Corp.s bonds is 0.55%. 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%
Global Satellite Corp. issues 8-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.
9.80%
4.85%
10.35%
9.65%
Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?
In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity. A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.
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