Question

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 5 % per year for each of the next three years and 4% 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 Liukin Holdings 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%
A	0.80%
A	1.05%
BBB	1.45%

Liukin Holdings Inc. issues ten-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. 

• 9.35% 

• 5.05% 

• 8.80% 

• 8.45% 

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

• A AAA-rated bond has less default risk than a BB-rated bond. 

• The yield on a AAA-rated bond will be higher than the yield on a BB-rated bond.

Answer 1

Real risk free rate Inflation premium Maturity risk premium Liqudity premium Default risk premium 2.80% 4.30% 0.90% 0.55% 0.80% =(5%*3+4%*7)/10 =0.1*(10-1)% Yield on the bond 9.35% "A AAA-rated bond has less default risk than a BB-rated bond."

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