LESSON 4: MANAGING CREDIT RISK IN MONEY MARKET

What is Cost of Debt?

The cost of debt is the return that a company provides to its debtholders and creditors. These capital providers need to be compensated for any risk
exposure that comes with lending to a company.

Since observable interest rates play a big role in quantifying the cost of debt, it is relatively more straightforward to calculate the cost of debt than the cost of
equity. Not only does the cost of debt reflect the default risk of a company, but it also reflects the level of interest rates in the market. In addition, it is an
integral part of calculating a company’s Weighted Average Cost of Capital or WACC.

Cost of debt refers to the total interest expense a borrower will pay over the lifetime of the loan.

The minimum acceptable rate of return (hurdle rate) on corporate investment is determined by the investors in financial markets.

BSP defined Interest as Price.

 Lending rate of return- Lenders
 Cost of debt- Borrowers

Solvency Ratios vs. Liquidity Ratios: An Overview

Solvency and liquidity are both terms that refer to an enterprise's state of financial health, but with some notable differences.
Solvency refers to an enterprise's capacity to meet its long-term financial commitments.
Liquidity refers to an enterprise's ability to pay short-term obligations—the term also refers to a company's capability to sell assets quickly to raise
cash.

Liquidity is often a more involved strategy than solvency due to it being a short-term measurement of business. Managing risk associated with liquidity is a
necessary component of a broader business-wide risk management system that should be in place to help maintain operations. Assessing prospective
funding needs and ensuring enough money is available at the right times to handle debt helps keep risk low. Because liquidity is associated with the short
term, regular tasks that can be done to manage risk include:

Monitoring and assessing current and future debt obligations

Planning for unexpected funding needs
Addressing daily liquidity obligations
Preparing to withstand any periods of liquidity stress

As risk is established and effectively managed, the next step is to prepare enough sources to continue to meet liquidity needs. This task includes looking to
several income sources, such as:

 Existing assets: bringing in cash from interest or principal payments from existing assets, which can include the collection of service fees or funds
from various transactions and sale of certain assets.
 Debt obligations: obtaining cash to manage debt through this route is highly dependent on an organization’s perceived financial condition and public
credit standing. It might not be an ideal source for a younger business or one that is emerging from financial difficulties.

 Equity: this source has the potential to be a costlier choice as well as a lengthier arrangement for managing liquidity than the other two options.
 Credit Risk and Interest Rates

Credit risk is a type of business risk. This is the risk that the borrower may not be able to repay its obligation. Such risk is included in valuation as a
factor to determine the cost of lending or financing using debt. Credit risk also affects the valuation of accounts receivable.

Theories related in Setting Interest Rates

According to Fabozzi and Drake, there are two economic theories that drive the interest rates. These are loanable funds theory and liquidity
preference theory.

1. Loanable funds theory assumes that it is ideal to supply funds when the interests are high and vice versa. This theory was introduced by Knut
Wicksell in 1900s.

Example:
Crane Corp. started divesting their funds when there is a global financial crisis and the interest are way high than normal, which they expect would allow them
to earn more during this situation. The theory observed by Crane Corp is __________.
a. Expectation Theory c. Market Segmentation Theory
b. Loanable Fund Theory d. Liquidity Preference Theory

2. On the other hand, liquidity preference theory was introduced by John Maynard Keynes and states that the interest rates are dependent on the
preference of the household whether they hold money or use it for investment. Hence, the longer the term, the higher the interest rates because
investors prefer short-term investments more.

The tenor of the investment also defines the riskiness of the repayment of debt. The longer the life of the debt, the riskier the repayment; hence, the
interest rate is higher. There are two economic theories that affect the term structure of interest rate. These are expectations theory and market segmentation
theory.

1. Expectation Theories

Expectation theories state that the interest rates are driven by the expectation of the lender or borrowers regarding the risks of the
market in the future. It can either be a pure expectation theory or biased expectation theory. Both theories understand how interest rate, or the
term, should be structured over time.

Pure (unbiased) expectations theory is based on the current data and statistical analysis to project the behavior of the market in the
future. They all rely on forward rates or the future interest rates based on their projection on the future prices. Of course, expectation on the
interest rates varies depending on the perspective and the maturity. Long-term interest rates (forward rates) reflect the market's expectations of
future short-term interest rates (spot rates).

For example, Company A needs to finance a project that will be operated in perpetuity. Company A applied for a loan to Company B
payable for 20 years. The prevailing interest rate at present is 7%. Based on the current environment, the market seems to worsen in the future.
How will the interest rate behave in the future? With the given information, Company B must assume a higher rate than 7% since the probability
that Company A may pay in the future is becoming low. The pure expectations shall be based on the strong estimates based on the uncertainty
of the future. The rates to be agreed should be reasonable enough for both parties otherwise one will not be fully compensated especially on the
part of the lenders. Observed that the pure expectations theory only relies on the term and not on other factors.

 Pure (unbiased) expectations theory- based on strong estimates of uncertainty, relies only on terms and not on other factors

Company A needs to finance a project that will be operated in perpetuity. Company A applied for a loan to Company B payable for 20 years. The prevailing
interest rate at present is 7%. Based on the current environment, the market seems to worsen in the future. How will the interest rate behave in the future?

With the given information Company B must assume a higher interest rate that 7% since the probability that Company A may pay in the future is becoming
low.
Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the
market's forecast for 1-year rates 1 year from now?

2-year rate now x 2-year rate now

------------------------------------------------------------ -1 = forecasted 1 year rate
1- year rate now

1.07 x 1.07 - 1 x 100= 9.04%

1.05
Suppose that the current one-year Treasury-bill rate is 3.15 percent and the expected one-year rate 12 months from now is 4.25 percent. According to the
unbiased expectations theory, what should be the current rate for a two-year Treasury security?

2-year rate now x 2-year rate now

------------------------------------------------------------ -1 = forecasted 1 year rate
1- year rate now

X*X - 1 x 100= 4.25%

1.0315

4.25% / 100 + 1= x * x
1.0315

1.0425 = x *x
1.0315

1.0425 x 1.0315= x * x

1.07533875 = x * x
Square root of 1.07533875= x
x= 3.70%

Biased Expectation Theory includes that there are other factors that affect the term structure of the loans as well as the interest to be
perceived moving forward. The forward rates will be affected or will be adjusted if the liquidity of the borrower will be weaker or stronger in the
future. The adjustment or increase on the interest rate is called the liquidity premium. Liquidity premium increases as the maturity lengthens.
This theory is called the liquidity theory. Another theory under the Biased Expectation Theory is the preferred habitat theory. This theory
does not only consider the liquidity but the risk premium as well but disregarding the consensus of the market on the future interest rates. The
habitat being referred here is the biased estimate over the market behavior in the future.

2. Market Segmentation Theory

 This theory assumes that the driver of the interest rates are the savings and investment flows. The maturities are segmented
depending on how the assets and liabilities were managed as well as the lenders on how they extend financing. It is the same with preferred
habitat theory however it does not assume that any of the players are willing to shift sector should opportunity to arise for the asset or liabilities
to be retired or lenders to offer higher rates.

Term structure, also known as the yield curve when graphed, is the relationship
between the interest rate of an asset (usually government bonds) and its time to
maturity

Interest rate is measured on the vertical axis and time to maturity is measured on the
horizontal axis.

Normally, interest rates and time to maturity are positively correlated. Therefore,
interest rates rise with an increase in the time to maturity. It results in the term
structure assuming a positive slope. The yield curve is often seen as a measure of
confidence in the economy for the bond market.

Therefore, investor preferences that favor short-term bonds over long-term bonds
would give rise to the standard upward sloping yield curve, whereas investor
preferences that favor long-term bonds over short-term bonds would give rise to
the inverted yield curve.

Determination of Interest Rates

The following should be considered assuming the cash flows have already been established:
● Interest rates in the industry
● Risk exposure
● Compensation on the market expectation

1. By the function of the risk and the compensation of the investor

Interest rate= Risk free rate* + debt margin**

*Risk free rate (ALSO CALLED NOMINAL RISK FREE RATE) = Real Risk free rate + inflation rate
**or debt spread or risk premium
 *************************************************************************************
2. By the function of the market value, par value and the interest paid by debt securities or bond

Interest = periodic interest payment + (Par value- Market value)

Term of bonds
_____________________________________________________________________________ x 100
Par value+ Market value
2

BSP cannot set the real interest rate because it cannot set the inflation expectations

PDS Group
(a) Organized market that was formed out of financial distress in 1997
(b) Provides full financial service from trading to clearing and settlement

Composed of:
1. Philippine Dealing and Exchange Corp. (PDEx) - trading services arm (fixed-income market)
2. Philippine Depository and Trust Corp (PDTC) - securities services
3. Philippine Securities Settlement Corp (PSSC) - payments and transfer services
4. PDS Academy for Market Development Corp (PDSA) - training center

Example #1:
MMM would like to borrow funds from NNN the following year. The risk free rate is 6% and the current inflation is 2%. The following year, the inflation is
expected to grow to 3%. NNN still finds that the 4.50% debt margin remains to be relevant.

What is the interest rate the NNN should impose to MMM?

Recalculate the Risk free rate because payment will be made in the future dates:
Risk free rate= Treasury bill rate
Real risk free rate= Risk free rate-Inflation rate
Year- current
Rfr= 6%- 2%
Rfr= 4%

Year -following year

Rfr=Rf-Ir
4%= Rf – 3%
4%+ 3%= Rf
Rf= 7%

Interest rate= risk free rate + debt margin

Interest rate= 7% + 4.5%= 11.5%
Will 11.5% acceptable to MMM? ____

Example # 2: @ PREMIUM= Nominal rate > Market rate

10% 8.18%
XXX issued bonds with 10% nominal rate for a P1,000 par value bonds payable for 20 years. The bonds were sold for P1,200. How much is the interest rate
of the XXX bonds in the market?

Interest = 100 + (1,000-1,200)

20
----------------------------- x 100
(1,000+ 1,200)
2
= 100 -10 / 1,100 x 100

= 8.18%

Example #3: @ DISCOUNT Nominal rate < Market rate

XXX issued bonds with 10% nominal rate for a P1,000 par value bonds payable for 20 years. The bonds were sold for P900. How much is the interest rate of
the XXX bonds in the market?

Interest = 100 + (1,000-900)

20
------------------------------------ x 100
(1,000+ 900)
2

= 100 + 5 / 950 x 100

= 11.05%

bonds Market Interest rate

@ premium Lower than the nominal rate
@ discount Higher than the nominal rate

RISK that are inherent in every financing transactions:

1. Default Risk/ Credit Risk

- Arise on the inability to make payments consistently
- May be quantified by determining the probability of the borrower to default in their payments in the duration of the loan

2. Liquidity Risk
- Identified by ensuring the business to be capable of meeting all its currently maturing obligation
- Risk is quantified by determining the opportunity cost of the lender on the period within which the borrowers were able to recoup

3. Legal Risk
- Dependent on the covenants set and agreed in between the lenders & borrowers
- Will arise upon the ability of any of the parties to comply with the covenants of the contract
 - Common defaults in the covenants:
● Maintaining the financial ratios
● Significant acquisition or disposal of assets
● Repayment of other obligation
● Declaration of dividends of any form without the consent of the lenders
4. Market Risk
- Impact of the market drivers to the ability of the borrowers to settle the obligation
- Most difficult to quantify
- Classified as a Systemic Risk
● Because it arises from external forces or based on the movement of the industry

Example:
Rules and standards are being set in a financial system in order to regulate the following market drivers, except:
a) Market competition
b) Market integrity
c) Market stability
d) Market profitability

Mitigating the Interest Rate Risks

 Inflation
 Tenor
 Other market risks

1. Spot Rates
- Interest rate or yield available for a particular time
- Actual rates and are not hedge
- The applicable interest rate is based on the prevailing market rate at the particular time
- Will be used to mitigate the risk by referring to historical yield vis-a-vis the forces that occur in those times

2. Forward Rates or Hedge Rates

- Contracted rates that fixed the rates and allow a party to assume such risk on the difference between the contracted rate and the spot rate

Lenders - would like a more conservative rate Borrowers - Aggressive or lower as much as possible versus the expected spot rate in the future

3. Swap Rate
- Another contract rate where a fixed rate exchange for a certain market rate at a certain maturity
- The one used as reference is the LIBOR (London Interbank Offered Rate. For the swap rate, it is normally the fixed portion of a currency
swap

London Interbank Offered Rate (LIBOR)

(a) Used to benchmark interest rates which is used as reference for international banks to borrow
(b) Calculated using the Intercontinental Exchange (ICE)
(c) LIBOR, which stands for London Interbank Offered Rate, was a benchmark interest rate that reflected the average rate at which banks in
London lent to each other, but it has been phased out and replaced by alternative benchmarks like SOFR.
The Secured Overnight Financing Rate (SOFR)
(a) is a benchmark interest rate that reflects the cost of borrowing cash overnight, secured by U.S. Treasury securities
(b) serves as a replacement for LIBOR.
(c) broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities in the repurchase agreement (repo) market.
(d) calculated as a volume-weighted median of transaction-level U.S. Treasury repurchase agreement data.

Swap rate yield curve

- Correlation of the swap rate and the maturity rate
- Useful for countries as reference for the credit risks and for future decisions

CREDIT RATINGS
- Affects the confidence level of the investors to countries or companies
- Determined by companies that are recognized globally that objectively assigns or evaluates countries & companies based on the riskiness of doing
business with them
- Driven by their ability to manage their liquidity and solvency in the long run - Higher grade, Lower default risk

FIVE major credit rating companies:

1. Standard & Poor’s Corporation
American financial services corporation
Founded in 1941 by Henry Varnum Poor in New York, US

Uses data gathered from 128 countries using more than 1,500 credit analysts to asses the creditworthiness to the industry

Categorized to Investment Grade scaled from AAA to BBB and Speculative Grade and scaled from BB to D

2. Moody’s Investors Service

Particularly on debt securities

Established in1909 in New York, USA

Gathers information from more than 130 countries, more than 4,000 non-financial corporate issues and more than 4,000 financial institutions

Employs more than 13,000 across the whole world

Scale: AAA to C

3. Fitch Ratings
Founded in 1914 in New York, USA
Owned by Hearst - a global information and services company

Provides credit opinions based on the credit expectations based on certain quantitative and qualitative factors that drive a company, they asses
based on the credit analysis and intensive research Conducts their assessment over more than 8,000 entities with 25 different currencies

Scale: AAA to D
Other Rating Agencies:
4. DBRS
● Established in 1976 in Toronto, Canada
● Fourth largest ratings agency
● Observes almost 50,000 securities worldwide
● Has offices in New York, Chicago, London, Frankfurt and Madrid
● Scale: AAA to C

5. CARE Ratings
● Started in 1993 based in India
● Based in Mumbai with parties in Brazil, Portugal, Malaysia and South Africa
● Scale: AAA to D

Philippine Rating Services Corporation is the only domestic credit rating agency that is accredited by the Securities and Exchange Commission and
recognized by the Bangko Sentral ng Pilipinas. It is also a founding member of the Association of Credit Rating Agencies in Asia (ACRAA), which now
counts thirty (30) domestic credit rating agencies in the Asian region as its members. PhilRatings actively participates in the development of the Philippine
capital market by implementing a national credit rating system.

The Bangko Sentral ng Pilipinas (BSP) has approved the recognition of PhilRatings as a domestic credit rating agency (CRA) for bank supervisory purposes.
PhilRatings is thus the first domestic CRA to be accredited by the BSP. Eligibility criteria for recognition include, among others: a minimum 5-year track record
in issuing reliable and credible ratings; a pool of experienced analysts; competent and experienced Board of Directors; an established rating methodology; and
that the CRA has an established record of independence, objectivity, and transparency.

In addition to the recognition by the BSP, PhilRatings has also been accredited by the Securities and Exchange Commission (SEC) as a credit rating agency
after its compliance with the requirements under SRC Rule 12.1 subject to faithful compliance with the reportorial and other requirements of said Rule,
applicable laws, circulars, rules and regulations and to further orders of the Commission.

PhilRatings is a BSP-recognized domestic external credit assessment instutition (ECAI) which can rate domestic debt issuances in relation to the BSP's
implementing guidelines of Basel II.

Standard & Poor's credit rating for Philippines stands at BBB+ with stable outlook. Moody's credit rating for Philippines was last set at Baa2 with stable
outlook. Fitch's credit rating for Philippines was last reported at BBB with negative outlook. In general, a credit rating is used by sovereign wealth funds,
pension funds and other investors to gauge the credit worthiness of Philippines thus having a big impact on the country's borrowing costs. This page includes
the government debt credit rating for Philippines as reported by major credit rating agencies.
A credit information system will directly address the need for reliable credit information concerning the credit standing and track record of
borrowers.

The R.A. No. 9510, otherwise known as the Credit Information System Act (CISA) of 2008, prescribed the powers and functions of the Credit Information
Corporation whose primary mandate is to:
Receive and consolidate basic credit data
Act as a central registry or central repository of credit information
Provide access to reliable, standardized information on credit history and financial condition of borrowers

What Is on a Credit Report?

The short answer to that question is: A lot!
The typical credit report will include personal identifying information: a list of credit accounts (including credit limit), type of account (credit card, mortgage, auto
loan, etc.), and your payment history on those accounts.

What Is Collateral Value?

The term collateral value refers to the fair market value of the assets used to secure a loan. Collateral value is typically determined by looking at the recent
sale prices of similar assets or having the asset appraised by a qualified expert.
Collateral value is one of the key aspects considered by lenders when reviewing applications for secured loans. In a secured loan, the lender has the right to
obtain ownership of a particular asset—called the "collateral" of the loan—if the borrower defaults on their obligation. In theory, the lender should recover all or
most of their investment by selling the collateral. Therefore, estimating the value of that collateral is a key step before any secured loan is approved.

Examples:

1. The size of a secured loan relative to its collateral value is known as the loan-to-value ratio (LTV).

For example, if a bank provides an P800,000 loan in order to purchase a house with a collateral value of P1 million, then its LTV ratio would be 80%.

2. AAA Inc. is exploring to issue a financial instrument next year. They are researching for a reasonable interest rate to offer. The financial instrument is
expected to cover for 180 days. Government Treasury Bills are being offered with the following rates: 30 – 1.5%; 60 – 2%; 90 – 2%; 180 – 2.50%; 360 – 3%.
Inflation was reported at 1.2%. Soju Inc. must be able to safeguard at least 3% of the risk for this issuance. The appropriate interest rate is

Risk free rate= Real Risk free rate + Inflation rate

Interest rate= Risk free rate + debt margin
I= (2.5% + 1.2%)+3%=6.70%

3. A financial institution allows a firm to borrow Php1,250,000 at 8% interest. The institution would require compensating balance of 10% of the face value of
the loan. The effective interest rate with this loan is _____.
I= 100,000/ (1,250,000 * 90%)= 8.9%

4. The interest that Capco Inc. must pay for the amount borrowed from a financial institution amounting to Php100,000 that will due in six months with an
interest rate is prime plus 2 percent, based on the market information the prime rate behave as follows: (i) 8.5% at the beginning of the loan; (ii) 9% after two
months from the issuance of the loan; (iii) 10% after 10 months from the issuance of the loan, is _______.

first 2 months 100,000 x 10.5% x 2/12= P1,750

3rd -6th month 100,000 x 11% x 4/12= 3,667
 Total interest P5,417
5. Company ABC has a P100,000 line of credit at Bank Z. The company must maintain the following compensating balances: 15% on outstanding loan and
10% on the unused portion of the line of credit. The company borrowed P60,000. The interest rate on the loan is 12%. What is the effective annual interest
rate?
The required deposit equals: P60,000 x 15% + P40,000 x 10% = P13,000
I= 7,200/ 60,000-13,000= 15.32%

6. You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds have no special covenants. The Wall Street Journal reports
that 1-year T-bills are currently earning 3.25 percent. Your broker has determined the following information about economic activity and Moore Corporation
bonds:

T-bills rate= Nominal/Real Risk Free Rate + Inflation Premium

Real Risk-Free Rate = 2.25%

Default Risk Premium = 1.15%
Liquidity Risk Premium = 0.50%
Maturity Risk Premium = 1.75%

a. What is the inflation premium?

T-bill Rate= RRFR + Inflation Premium

3.25= 2.25+ N
N= 1%

b. What is the fair interest rate on Moore Corporation 30-year bonds?

FIR= 2.25+1.15+0.50+1.75+1+ 0= 6.65%

Fair Interest Rate/Quoted Nominal Rate= Real risk-free rate + Inflation risk premium + Liquidity risk premium + Maturity risk premium + Default risk
premium + Special Covenant Premium

7. A particular security’s equilibrium rate of return is 8 percent. For all securities, the inflation risk premium is 1.75 percent and the real risk-free rate is 3.5
percent. The security’s liquidity risk premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has no special covenants. Calculate the
security’s default risk premium.

Fair Interest Rate= Inflation risk premium + Real risk-free rate + Liquidity risk premium + Maturity risk premium + Default risk premium + Special
Covenant Premium= 1.65%

8. The nominal rate of return of Sonic Holdings Company for their corporate bond with the real interest rate of 5%, inflation risk premium is 2%, during this
time the Phil Treasury Bill is 5%, maturity risk premium of 3%, default risk of 1%, and liquidity risk premium is 1%.

T-Bills= RRFR + IP
5=RRFR+2%
RRFR= 3%

Nominal Rate of return= 3+2+3+1+1= 10%

Nominal Rate of return= maturity risk premium + inflation risk premium + real risk free rate + default risk + liquidity risk premium
9. The real risk-free rate of interest is 3 percent. Inflation is expected to be 4 percent this coming year, jump to 5 percent next year, and increase to 6 percent
the year after (Year 3). According to the expectations theory, what should be the interest rate on 3-year, risk free securities today?

To calculate the interest rate on 3-year, risk-free securities today, we take the average of the nominal interest rates across the three years, which are derived
by adding the real risk-free rate to the expected inflation rate for each year. Consequently, the interest rate is 8%

10. Currently, a 5 year T-bonds have a yield of 5% and 5 year corporate bonds yield 6.75%. Also, Corporate Bonds and T-bonds have a liquidity premium of
0.3% and 0% consecutively. The maturity risk premium on both bonds is 1.15%. What is the default risk premium?

Tbond
5%= Real risk free rate + liquidity premium + maturity risk premium (Treasury bonds have no default risk because the
Govt guarantees performance with its full faith and credit.)

5%= Real risk free rate + 0% + 1.15%

Real risk free rate = 3.85%

Corporate bond
6.75%= Real risk free rate + liquidity premium + maturity risk premium + default risk premium
6.75%= 3.85% + 0.3% + 1.15% + DRP
DRP= 1.45%
 Sample Problem Solvings. MAKE YOUR OWN SOLUTIONS. Answers are provided below.
1. XXX Company, a financial institution, allows AAA Company to borrow P1,300,000 with 8% interest. XXX would require a compensating balance of 8% of the
face value of the loan. What is the effective interest rate of the loan (round off your answer to two decimal places)? 8.70%

2. YYY Company would like to borrow funds from BBB Company. The risk-free rate is 5% and the current inflation is 1%. In the following year, the inflation is
expected to grow to 2%. YYY still finds that the 3% margin remains to be relevant. What is the interest rate that BBB should impose to YYY (round off your
answer to two decimal places)? 9%

3. Considering an investment in 30-year bonds issued by an AAA+ Corporation.The Wall Street Journal reports that 1-year T-bills are currently earning 4.05 %.
Your broker has determined the following information about economic activity and AAA+ Corporation bonds:
Real Risk-Free Rate = 2.25%
Default Risk Premium = 1.15%
Liquidity Risk Premium = 0.50%
Maturity Risk Premium = 1.75%
Special covenant = 1%

What is the fair interest rate on AAA+ Corporation 30-year bonds? 8.45%

4. Suppose that the current one-year Treasury Bill rate is 3.15% and the expected one-year rate 12 months from now is 4.25%. According to the unbiased
expectations theory, what should be the current rate for a two-year treasury security?3.7%

5. Suppose 1 year T-bills currently yield 7% and the future inflation rate is expected to be constant at 3.2% per year. What is the real risk free rate? 3.80%

6. Suppose a 10-year T-bonds have a yield of 5.3% and 10-year corporate bonds yield 6.75%. Also corporate bonds have a 0.25% liquidity premium versus a
zero liquidity premium for T-bonds, and the maturing risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium
on corporate bonds? 1.20%

7. An investor requires a 3% increase in purchasing power in order to induce her to lend. She expects inflation to be 2% next year. The nominal rate she must
charge is about is? 5%

8. A Corporation’s 5-year bonds yield 6.2% and 5-year T-bonds yield 4.4%. The real risk free rate is 2.5%, inflation premium for a 5-year bonds is 1.5%, default
risk premium is 1.3% versus 0% for T-bonds, and the maturity risk premium for all bonds is found with the formula ((t-1) x 0.1%), where t= maturity number of
years. What is the liquidity premium on bonds? 0.50%

9. Given the following data, find the expected rate of inflation during the next year. r* = real risk-free rate = 3%. Maturity risk premium on 10-year T-bonds =
2%. It is zero on 1-year bonds, and a linear relationship exists. Default risk premium on 10-year, A-rated bonds = 1.5%. Liquidity premium = 0%. The interest
rate on 1-year T-bonds = 8.5%. 5.5%

10. Koy Corporation's 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is
IP = 1.75%, the liquidity premium for Koy's bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula
MRP = (t – 1) × 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Koy's bonds? 1.1%