Question

4. Calculating interest rates Aa Aa E The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next three years and 3% 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 Pellegrini Southern Inc.'s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Default Risk Premium Rating U.S. Treasury AAA AA A BBB 0.60% 0.80% 1.05% 1.45% Pellegrini Southern Inc. issues 12-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. O 5.75% 09.00% O 7.95% 0 7.90% 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. O

Answer 1

Part 1:
The value of yield is calculated as:
Yield=Real risk free rate + Inflation premium + Default risk premium + Liquidity premium + Maturity risk premium

Time period is 12 years
Average inflation premium=(4%*3+3%*9)/12
=(0.12+0.27)/12
=(0.39)/12
=0.0325

Maturity risk premium=0.1*(t-1)%
So, when time period t is 12 years, we get:
Maturity risk premium=0.1*(12-1)%=0.011

Real risk free rate is 2.8%
For a AA rated bond the default risk premium is 0.80%
Liquidity premium =1.05%

Substituting the values, we get;

Yield=2.8% + 0.0325 + 0.80% + 1.05% + 0.011
=0.09 or 9%

Answer: Hence, the yield is 9.00%

Part 2:
The second option is correct. Higher Inflation expectations increase the nominal interest rate demanded by investors
The yield on US treasury securities does not remain static always, it changes with change in interest rates.