Question

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 5% per year for each of the next two years and 4% 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 Pandar 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%

Pandar Corp. issues eight-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.

4.85%

8.55%

9.10%

8.40%

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

A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.

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

Answer 1

Inflation premium is average of inflation over life of bond = [(5% * 2) + (4% * 6)]/8 = 4.25%

Maturity risk premium = 0.1(8 - 1)% = 0.7%

Default risk premium for AA bond = 0.80%

Nominal yield = 2.8% + 4.25% + 0.7% + 0.80% + 0.55% = 9.10%

A AAA-rated bond has a less default risk than a BB-rated bond. This is because a higher credit rating implies lower probability of default and hence lower default risk.