On the first day of your summer internship, you’ve been assigned to work with the Chief Financial Officer (CFO) of SanBlas Jewels Inc. Not knowing how well trained you are, the CFO has decided to test your understanding of interest rates. Specifically, she asked you to provide a reasonable estimate of the nominal interest rate for a new issue of Aaa-rated bonds to be offered by SanBlas Jewels Inc. The final format that the chief financial officer of SanBlas Jewels has requested is that of equation (2-1) in the text. Your assignment also requires that you consult the data in Table 2-2. Some agreed-upon procedures related to generating estimates for key variables in equation (2-1) follow.
a. The current 3-month Treasury bill rate is 2.96 percent, the 30-year Treasury bond rate is
5.43 percent, the 30-year Aaa-rated corporate bond rate is 6.71 percent, and the inflation
rate is 2.33 percent.
b. The real risk-free rate of interest is the difference between the calculated average yield on
3-month Treasury bills and the inflation rate.
c. The default-risk premium is estimated by the difference between the average yield on Aaarated bonds and 30-year Treasury bonds.
d. The maturity premium is estimated by the difference between the average yield on 30-year
Treasury bonds and 3-month Treasury bills.
e. SanBlas Jewels’ bonds will be traded on the New York Bond Exchange, so the liquidity premium will be slight. It will be greater than zero, however, because the secondary market for
the firm’s bonds is more uncertain than that of some other jewel sellers. It is estimated at 4
basis points. A basis point is one one-hundredth of 1 percent. Now place your output into the format of equation (2-1) so that the nominal interest rate can be estimated and the size of each variable can also be inspected for reasonableness and discussion with the CFO.
nominal interest rate = real risk-free interest rate
+ inflation-risk premium
+ default-risk premium
+ maturity premium
+ liquidity premium
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