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# Determination of Interest Rates

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The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 5% per year for each of the next three years and 4% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.l(t - 1)%, where t is the security's maturity. The liquidity premium on all Pettigrew Power Co.'s bonds is 0.75%. The following table shows the current relationship between bond ratings and default risk premiums:

Rating Default Risk Premium
U.S. Treasury -
AAA 0.60%
AA 0.80%
A 1.05%
BBB 1.45%

What is the yield on a seven-year, AA-rated bond issued by Pettigrew? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average.

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#### Solution Preview

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 5% per year for each of the next three years and 4% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.l(t - 1)%, where t is the security's maturity. The liquidity premium on all Pettigrew Power Co.'s bonds is 0.75%. The following table shows the current relationship between bond ratings and default risk ...

#### Solution Summary

Calculates the yield on a bond given the risk premium.

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