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 two 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 Gauge Imports Inc.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% |
Gauge Imports Inc. issues 10-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.
9.70%
5.05%
10.25%
9.35%
Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?
A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.
In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity.
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