3. Calculating interest rates The real risk-free rate (r*) is 2.8% and is expected to...
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Accounting
3. Calculating interest rates
The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next two years and 3% thereafter.
The maturity risk premium (MRP) is determined from the formula: 0.1(t 1)%, where t is the securitys maturity. The liquidity premium (LP) on all Harrington Horticulture Co.s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):
Rating
Default Risk Premium
U.S. Treasury
AAA
0.60%
AA
0.80%
A
1.05%
BBB
1.45%
Harrington Horticulture Co. issues eleven-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.
5.15%
7.33%
7.78%
8.33%
Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?
An AAA-rated bond has less default risk than a BB-rated bond.
A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.
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