On the first day of your summer internship, you’ve been assigned to work with the chief financial officer (CFO) of Carat Designs Corporation. As one of your assignments, you have been asked to estimate the nominal interest rate for a new issue of a bond. The final format that the chief financial officer of Carat Designs has requested is that of equation (2-1) in the text.

Some agreed-upon procedures related to generating estimates for key variables in equation (2-1) follow.

a. The current 3-month Treasury bill rate is 3 percent and the inflation rate is 2 percent.

b. The 30-year Treasury bond rate is 5 percent and the 30-year AAA-rated corporate bond rate is 7 percent.

c. Carat Designs’ bonds will be traded on the Italian Stock Exchange, so the liquidity-risk premium will be slight. It will be greater than zero, however, because the secondary market for the firm’s bonds is more uncertain than that of some other jewel sellers. It is estimated at 5 basis points. A basis point is one one hundredth of 1 percent.
Now place your output into the format of equation (2-1) so that the nominal interest rate can be estimated and the size of each variable can also be inspected for reasonableness and discussion with the CFO.

Transcribed Image Text:

Nominal interest rate = real risk-free interest rate +inflation premium +default-risk premium + maturity-risk premium + liquidity-risk premium (2-1)