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 5% per year for each of the next two 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 Harrington Horticulture Co.'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% 1.05% BBB 1.45% onds. What is the yield on bonds? Disregard cross-p Harrington Horticulture Co. -year, AA- the duct terms; averaging is required, use the arithmetic average. O 8.35% O 5.05% O 8.70% O 9.25% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? O Higher inflation expectations increase the nominal interest rate demanded by investors. O The yield on an AAA-rated bond will be higher than the yield on a BB-rated bond.

Answer 1

1.Average inflation premium =[ ( 5% *2 ) +( 4%*8) ]/ 10 = 4.2%

Maturity risk premium = 0.1 ( 10-1)% = 0.9%

Yield = risk free rate + Average inflation premium + Maturity risk premium+ Liquidity premium + Default risk premium

= 2.8% + 4.2% + 0.9% + 0.55% + 0.8%

= 9.25%

Option , 9.25%

2. Higher inflation expectations increase the nominal interest rate demanded by investors.