Ch $06$: Assignment $-$ Interest$*$Rates

The real risk$-$free rate $(r^{**})$ is $2\mathrm{.}8\%$ and is expected to remain constant. Inflation is expected to be $3\%$ per year for each of the next two years and $2\%$

thereafter.

The maturity risk premium $($MRP$)$ is determined from the formula: $0\mathrm{.}1(t-1)\%,$ where $t$ is the security$\text{'}$s maturity. The liquidity premium $($LP$)$ on all

Smith and Carter Inc.$\text{'}$s bonds is $0\mathrm{.}55\%.$ The following table shows the current relationship between bond ratings and default risk premiums $($DRP$)$:

Smith and Carter Inc. issues $6-$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.

$6\mathrm{.}43\%$

$6\mathrm{.}98\%$

$6\mathrm{.}48\%$

$4\mathrm{.}65\%$

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.