Question

(1) Assume the expected inflation rates for the next five years are as follows:

Year                          Inflation Rate

    1                                       8.0%

    2                                       6.0

    3                                       4.0

    4                                       3.0

    5                                       5.0

In Year 6 and thereafter, inflation is expected to be 3 percent. The maturity risk premium (MRP) is 0.1 percent per year to maturity for bonds with maturities greater than six months, with a maximum MRP equal to 2 percent. The real risk-free rate of return is currently 2.5 percent, and it is expected to remain at this level long into the future. The default risk premium for corporate bonds rated AAA is 1.5 percent whereas it is 4 percent for corporate bonds rated B. Compute the interest rates on AAA-and B-rated corporate bonds with maturities equal to one year, two years, three years, four years, five years, 10 years, 20 years, and 30 years.

Answer 1

As per rules I am answering the first 4 sub parts of this question

Interest rates on AAA bonds

Interest rate = RR+ IP+ DRP + MRP + LP

Inflation premium(IP) is taken as average of previous years.There is no Liquidity premium(LP)

Interest rate on 1 year bond= 2.5%+ 8%+1.5%+ 0.1%*1

=12.1%

Interest rate on 2 year bond= 2.5%+( 8%+6%)/2 +1.5%+ 0.1%*2

=11.2%

Interest rate on 3 year bond= 2.5%+( 8%+6%+4%)/3 +1.5%+0.1%*3

=10.3%

Interest rate on 4 year bond= 2.5%+( 8%+6%+4%+3%)/4 +1.5%+0.1%*4

=9.65%

Interest rate on 5 year bond= 2.5%+( 8%+6%+4%+3%+5%)/5 +1.5%+0.1%*5

= 9.7%

Year	RR	IP	DRP	MRP	Interest rate
1	2.50%	8%	1.50%	0.001	12.10%
2	2.50%	7.00%	1.50%	0.002	11.20%
3	2.50%	6.00%	1.50%	0.003	10.30%
4	2.50%	5.25%	1.50%	0.004	9.65%
5	2.50%	5.20%	1.50%	0.005	9.70%