Assume the real risk free rate is 1% and expected inflation is 2% each year for years 1-4 and 3% each year for years 5-10. 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 required return on a 9-year, A-rated, Senior bond issued by a large company?

a) 7% b) 7.4% c) 7.8% d) 8.3%

2. A 6-year, Junior bond issued by a small company has a required return of 7.5%. What is it’s rating?

a) AAA b) A c) BB d) B