Question

You are given the following information: • r* = 1.5% • Investors expect inflation to average 3% per year into the foreseeable future • The MRP on 200 year bonds = 2% • The LP on U.S. and Yubaba Inc. bonds = 0 • The interest rate on a 20 year loan to Yubaba Inc. is 1.25 times the rate on a 20 year loan to the U.S. government.

c) What is the DRP on a 20 year loan to Yubaba Inc.?

Answer 1

Let the interest rate on US bond be r_US and for Yubaba be r_YB. Now we know that :

r_US = r* + Inflation + MRP + DRP + LP

We are given r* = 1.5%, Inflation expectation = 3%, MRP on 20 year bond = 2%, DRP for US government will be 0 and LP = 0

Then r_US = 1.5% + 3% + 2% + 0 + 0= 6.5%

Additionally we are given r_YB = r_US * 1.25, hence r_YB = 6.5% * 1.25 = 8.125%

using the above equation: r_YB = r* + Inflation + MRP + DRP + LP

8.125% = 1.5% + 3% + 2% + DRP + 0 or DRP = 1.625%