Question

Calculating Interest rates

The real risk-free (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 7% per year for each of the next three 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 premiums (LP) on all BTR Warehousing's bonds is 1.05%. 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%
A	1.05%
BBB	1.45%

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. Answers to choose from: (5.65%, 10.92%, 11.92%, 10.87%)

Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? Answers to choose from: (The yield on a AAA-rated bon will be higher than the yield on a BB-rated bond. Higher inflation expectations increase the nominal interest rate demanded by investors.)

Answer 1

Inflation premium is average of inflation over life of bond.

For 11 year bond, inflation premium = [(7% * 3) + (6% * 8)]/11 = 6.27%

Maturity risk premium = 0.1(11 - 1)% = 1.0%

Nominal yield = 2.80% + 6.27% + 0.80% + 1.05% + 1.0% = 11.92%

Part 2:

Correct statement is: Higher inflation expectations increase the nominal interest rate demanded by investors.

This can be deferred from the formula above, higher interest rate implies higher inflation premium.