finance problems

CHAPTER 6

Α. The real risk-free rate of interest, r*, is 3%; and it is expected to remain constant over time. Inflation is expected to be 3% per year for the next 3 years and 4% per year for the next 5 years. The maturity risk premium is equal to 0.1 × (t − 1)%, where t = the bond's maturity. The default risk premium for a BBB- rated bond is 1.3%.

1. What is the average expected inflation rate over the next 4 years? 2. What is the yield on a 4-year Treasury bond? 3. What is the yield on a 4-year BBB-rated corporate bond with a liquidity premium of 0.4%? 4. What is the yield on an 8-year Treasury bond? 5. What is the yield on an 8-year BBB-rated corporate bond with a liquidity premium of 0.4%? 6. If the yield on a 9-year Treasury bond is 7.3%, what does that imply about expected inflation in 9

years?

Β. You read in The Wall Street Journal that 30-day T-bills are currently yielding 3.5%. Your brother-in- law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums:

• Inflation premium = 2.25% • Liquidity premium = 0.6% • Maturity risk premium = 1.8% • Default risk premium = 2.15%

On the basis of these data, what is the real risk-free rate of return?

C. Treasury bond that matures in 10 years has a yield of 5.5%. A 10-year corporate bond has a yield of 7%. Assume that the liquidity premium on the corporate bond is 0.5%. What is the default risk premium on the corporate bond?

D. An investor in Treasury securities expects inflation to be 2.5% in Year 1, 3.2% in Year 2, and 3.8% each year thereafter. Assume that the real risk-free rate is 2.75% and that this rate will remain constant. Three- year Treasury securities yield 5.75%, while 5-year Treasury securities yield 6.50%. What is the difference in the maturity risk premiums (MRPs) on the two securities; that is, what is MRP5 − MRP3?