Question

Drongo Corporation's 4-year bonds currently yield 7.7 percent and have an inflation premium of 3.7%. The real risk-free rate of interest, r∗, is 2.6 percent and is assumed to be constant. The maturity risk premium (MRP) is estimated to be 0.1%(t−1), where t is equal to the time to maturity. The default risk and liquidity premiums for this company's bonds total 1.1 percent and are believed to be the same for all bonds issued by this company. If the average inflation rate is expected to be 4 percent for years 5 and 6 , what is the yield on a 6 -year bond for Drongo Corporation?

a) 8.00%
b) 8.50%
c) 9.00%
d) 9.50%
e) 10.00%

Answer 1

The yield on a 6-year bond for Drongo Corporation, considering the real risk-free rate, inflation premium, maturity risk premium, and default and liquidity premiums, is calculated to be 8.2%. This is closest to the given option of 8.50%.

Step-by-step explanation:

The yield on a 6-year bond for Drongo Corporation can be calculated by considering the real risk-free rate of interest, the inflation premium, the maturity risk premium (MRP), and the combined default and liquidity premiums. Since we know the real risk-free rate (r*) is 2.6%, the given bond's inflation premium for the first 4 years is 3.7%, and the average inflation rate for years 5 and 6 is expected to be 4%, we can calculate the required yield. We also need to add the maturity risk premium, which is 0.1%(t-1), and the total default risk and liquidity premiums, which are 1.1%. For a 6-year bond, the MRP is 0.1%(6-1) = 0.5%. Adding these up, the yield for a 6-year bond would be r* + average inflation rate + MRP + default risk and liquidity premiums, which amounts to 2.6% + 4% + 0.5% + 1.1% = 8.2%. This yield is closest to option b) 8.50%.