Question

Use the following information to calculate the interest rate on an eight year bond just issued by Becher inc. show work

inflation: next two years = 2.5%, year three and beyond = 4.5%
Pure rate= 2.0%
Maturity risk premium= zero for a 1 year maturity, increasing by .1% each year thereafter
Default risk premium= 1.5%
Liquidity risk premium = 0.0% for treasuries; 0.5% for corporate bonds
a. 7.7%
b. 8.2%
c. 8.7%
d. 9.2%
e. 9.4%

Answer 1

c. 8.7%

Step-by-step explanation:

Inflation for the next year is 2.5% and year 3 and beyond is 4.5%

Pure rate is 2.0%

Maturity Risk premium (MRP) is 0 for a 1-year maturity and increasing by 0.1% each year

Default Risk Premium (DRP) is 1.5%

Liquidity Risk Premium(LRP) is 0.0% for treasuries, 0.5% for Corporate bond

Interest rate = Pure rate + Inflation + LRP + MRP + DRP

= 2 + Inflation + 0.5 + (0.1*7) + 1.5%

= 2 + {(2 years * 2.5) + (6 years * 4.5) / 8} + 0.5 + (0.1*7) + 1.5%

= 2% + 4% + 0.5% + 0.7% + 1.5%

= 8.7%