Question

The real risk-free rate (r*) is 2.8 %and is expected to remain constant. Inflation is expected to be 7 %per year for each of the next four years and 6 %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 BTR Warehousing's bonds is 0.55 %. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

BTR Warehousing issues 11 -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.

• 5.15 %

• 11.51 %

• 10.96 %

• 10.51 %

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

• A B88-rated bond has a lower default risk premium as compared to a MM-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.

Answer 1

Nominal Yield on a bond = Real Risk Free Rate + Default Risk Premium + Maturity Risk Premium + Liquidity Risk Premium + Inflation Premium

Now, the bond in question is a AA-rated bond, so

Default risk premium = 0.80% (from table)

Inflation Premium = [(7% * 4) + (6% * 7)]/11 = 6.36%

Nominal Yield = 2.8% + 0.80% + 0.1*(11-1)% + 0.55% + 6.36%

Nominal Yield = 11.51%

Question 2:

Correct option is statement 2. Statement 1 is incorrect because lower the rating, higher would be the default risk premium (evident from table in question). Statement 2 is correct. Maturity risk premium would increase as the maturity period increases and hence yield would increase as well.