Exam 5: The Cost of Money Interest Rates

Assume that r* = 1.0%;the maturity risk premium is found as MRP = 0.2%(t − 1)where t = years to maturity;the default risk premium for AT&T bonds is found as DRP = 0.07%(t − 1);the liquidity premium is 0.50% for AT&T bonds but zero for Treasury bonds;and inflation is expected to be 7%,6%,and 5% during the next three years and then 4% thereafter.What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds?

Expectations of high inflation lead to low interest rates and vice versa.

You read in The Wall Street Journal that 30-day T-bills currently are yielding 8 percent.Your brother-in-law,a broker at Kyoto Securities,has given you the following estimates of current interest rate premiums: Inflation premium 5%Liquidity premium 1%Maturity risk premium 2%Default risk premium 2%Based on these data,the real risk-free rate of return is

All else equal,the maturity risk premium tends to decline when interest rate volatility increases.

The nominal rate of interest is defined as the sum of the nominal risk-free rate of return and the expected inflation rate.