Question

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 three 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 Rink Machine Co.’s bonds is 0.55%. 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%

Rink Machine Co. issues nine-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.

a) 4.95%

b) 6.73%

c) 7.28%

d) 6.48%

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

a) An AAA-rated bond has less default risk than a BB-rated bond.

b) The yield on U.S. Treasury securities always remains static.

Answer 1

For a corporate bond,

Inflation premium is average of inflation over life of bond.

Inflation premium = [(3% * 3) + (2% * 6)]/9 = 2.33%

Maturity risk premium = 0.1(9 - 1)% = 0.80%

Nominal yield on bond = 2.8% + 2.33% + 0.80% + 0.80% + 0.55% = 7.28%

Part 2:

Correct answer is: An AAA-rated bond has less default risk than a BB-rated bond.

Higher the rating, lower is the probability of default.