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 3% per year for each of the next two years and 2% 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 Tahoe Hydroponics's bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Default Risk Premium Rating U.S. Treasury AAA AA 0.60% 0.80% 1.05% 1.45% BBB Tahoe Hydroponics issues 13-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. 7.50% 6.95% O 5.35% 6.30% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? The yield on U.S. Treasury securities always remains static. Higher inflation expectations increase the nominal interest rate demanded by investors.

Answer 1

Defalt Risk Premium on AA Bond = 0.80% I Matweity Risk premium_ 0,1(t-1).lv < 0,1 (13-1) olo 11.20 1 liquidity Premium 10.554 Inflatim Premium for next 13 year. Average Inflatim = (3x2)+ (2x17) Rute 13 = 6 + 22 13 - 28 3 -12.15/ Yield on Tahoe hydroponics bonds; Risk free rate 2.8% + Default RISK premium 0.8 thatwrity Risk Premium 4.2% + Liauidity Rish Premium 0.55% & inflatim Premium 2.15.1. Call 7.5: 17 Page No.

So here above option (a) is correct.

For another question Second statement Higher Inflation Expections Increase The Nominal Interest Rate Denominated By Investors. Because the Inflation Increase the Purchasing power of investors so to Reduce so to maintain same purchasing power investor will require more return on same Investment so as the Inflation Increase the expections of Nominal Interest rate increase.

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