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The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected...

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 6% per year for each of the next five years and 5% 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 National Transmissions Corp.’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%

National Transmissions Corp. issues 14-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.

10.81%

9.51%

10.26%

5.45%

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Answer #1

Yield on the bond = Real risk free rate + inflation premium + liquidity premium + maturity risk premium + default risk premium

Real risk free rate = 2.8 %

inflation premium = inflation premium will be arithematic average of the inflation premium for 14 years

= (6*5 + 5*9 ) / 14 = 5.36%

liquidity premium = 0.55%

maturity risk premium = 0.1 ( t-1)% = 0.1 ( 14 -1)=1.3%

default risk premium = 0.80% as the bond in question is AA rated

Yield on the bond = 2.8 + 5.36 + 0.55 + 1.3 +0.8 = 10.81%

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