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Assume the real risk free rate is 2% and expected inflation is 3% for the next 2 years and 4% for every year after that. The Maturity risk premium is .1% for every year until maturity. The Default risk premium increases by .5% for every drop in a bond’s rating (Treasury securities have a 0% premium, AAA bonds have a .5% premium, AA bonds have a 1% premium, A bonds have a 1.5% premium, and so on). Junior or Subordinated bonds have a 1% Seniority risk premium (Senior or Unsubordinated bonds have a 0% risk premium along with Treasury Securities). Finally, the Liquidity risk premium is 2% for small companies and 1% for large companies, and 0% for Treasury Securities.
1. What is the interest rate on a 6-year, B-rated, Subordinated bond issued by a large company?
a) 9.1%
b) 9.9%
c) 10.2%
d) 11.27%
2. A 4-year, Senior bond issued by a small company has an interest rate of 9.8%. What is it’s rating?
a) AA
b) A
c) BBB
d) BB
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The investment decision process
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