Question

Assume that the real risk-free rate is r = 2.5% and the average expected inflation rate is 3% for each future year. The DRP and LP for Bond X are 1% each, and the applicable MRP is 1.5%. What is Bond X's interest rate?

A. 9%
B. 10.5%
C. 6%
D. 4.5%
E. 7.5%

Answer 1

The interest rate for Bond X is found by adding the real risk-free rate, expected inflation rate, Default Risk Premium (DRP), Liquidity Premium (LP), and Maturity Risk Premium (MRP), which totals to 9%. Hence, the correct answer is A. 9%.

Step-by-step explanation:

To calculate Bond X's interest rate, you need to add the real risk-free rate, the expected inflation rate, the Default Risk Premium (DRP), the Liquidity Premium (LP), and the Maturity Risk Premium (MRP). The sum of these rates provides the nominal interest rate on the bond.

In this case, the real risk-free rate (r) is 2.5%, the expected inflation rate is 3%, the DRP for Bond X is 1%, the LP is also 1%, and the MRP is 1.5%. Therefore, the interest rate for Bond X can be calculated as follows:

• Real risk-free rate (r): 2.5%
• Expected inflation rate: 3%
• Default Risk Premium (DRP): 1%
• Liquidity Premium (LP): 1%
• Maturity Risk Premium (MRP): 1.5%

Adding these together gives us:

2.5% + 3% + 1% + 1% + 1.5% = 9%.

Therefore, the correct answer is A. 9%.

Answer 2

Bond X's interest rate is calculated by summing the real risk-free rate, the expected inflation rate, the default risk premium, the liquidity premium, and the maturity risk premium, which gives us a total of 9% (Option A).

Step-by-step explanation:

The student asked for the calculation of Bond X's interest rate given several factors.

To calculate the interest rate of the bond, known as the yield to maturity, we need to combine the real risk-free rate (r), the average expected inflation rate, the default risk premium (DRP), the liquidity premium (LP), and the maturity risk premium (MRP).

In this case, the formula would be:

Interest Rate = r + Inflation Rate + DRP + LP + MRP

Using the values provided:

Interest Rate = 2.5% + 3% + 1% + 1% + 1.5% = 9%

Thus, the correct answer is A. 9%.