Question

Determinants of Interest Rate for Individual Securities You are considering an investment in 30-year bonds issued by a corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 3.80 percent. Your broker has determined the following information about economic activity and the corporation bonds:

Real interest rate = 3.15%
Default risk premium = 3.05%
Liquidity risk premium = 1.35%
Maturity risk premium = 2.80%

What is the inflation premium? What is the fair interest rate on the corporation's 30-year bonds?

Multiple Choice

A) .65% and 11.00%, respectively

B) .65% and 2.20%, respectively

C) .65% and 10.35%, respectively

D) 3.80% and 14.15%, respectively

Answer 1

Answer is A.

Nominal Interest rate = Real Interest rate + inflation

T-bills are quoted at nominal interest rate. Hence, nominal interest rate = 3.8%, real interest rate = 3.15%. => Inflation premium = 3.8% - 3.15% = 0.65%.

Fair interest rate on bonds = T-bill yield + Liquidity risk premium + default risk premium + maturity risk premium

(Remember, T-bill already has inflation premium accounted in it, so we don't need to add inflation premium)

Fair interest rate on bonds = 3.8% + 1.35% + 3.05% + 2.80% = 11.00%