Question

Determinants of Interest Rates

Using the following DATA:

R*= 4.25%    

I₁ = 2%    

I₂ = 4%     

I₃ = 5%    

I_4→= 6.5%

MRP = .40% ( t - 1) (NOTE: This is a PERCENTAGE, not a DECIMAL MRP!) t = number of years to maturity

DRP = 7.2%    

LP = 2.8%

CALCULATE:

4 year TREASURY BOND RATE

6 year CORPORATE BOND RATE

Answer 1

Calculation of 4 year treasury bond rate:

Average inflation = (2% + 4% + 5% + 6.5%) / 4 = 4.375%

MRP = 0.40 * (4 - 1)% = 1.2%

4 year treasury bond rate = Real risk free rate + average inflation + MRP
= 4.25% + 4.375% + 1.2%
= 9.825% or 9.83%

4 year treasury bond rate = 9.825% or 9.83%

Calculation of 6 year corporate bond rate:

Average inflation = (2% + 4% + 5% + 6.5% + 6.5% + 6.5%) / 6 = 5.08%

Average inflation = 0.40 * (6 - 1)% = 2%

6 year corporate bond rate = Real risk free rate + average inflation + MRP + DRP + LP
= 4.25% + 5.08% + 2% + 7.2% + 2.8%
= 21.33%

6 year corporate bond rate = 21.33% (Rounded to 2 decimal places)