Problem 6-3 Expected Interest Rate A) The real risk-free rate is 2.75%. Inflatio
ID: 2802745 • Letter: P
Question
Problem 6-3
Expected Interest Rate
A) The real risk-free rate is 2.75%. Inflation is expected to be 1.75% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero.
What is the yield on 2-year Treasury securities? Do not round intermediate calculations. Round your answer to two decimal places.
%
B) What is the yield on 3-year Treasury securities? Do not round intermediate calculations. Round your answer to two decimal places.
%
Expected Interest Rate
C) The real risk-free rate is 2.85%. Inflation is expected to be 2.2% this year, 4.6% next year, and 2.15% thereafter. The maturity risk premium is estimated to be 0.05(t - 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? Do not round your intermediate calculations. Round your answer to two decimal places.
%
Default Risk Premium
D) A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a yield of 8.5%. Assume that the liquidity premium on the corporate bond is 0.55%. What is the default risk premium on the corporate bond? Round your answer to two decimal places.
%
Maturity Risk Premium
E) The real risk-free rate is 3.25%, and inflation is expected to be 2% for the next 2 years. A 2-year Treasury security yields 8.25%. What is the maturity risk premium for the 2-year security? Round your answer to two decimal places.
%
Real Risk-Free Rate
F) You read in The Wall Street Journal that 30-day T-bills are currently yielding 4.8%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums:
Inflation premium = 2.5%
Liquidity premium = 1.1%
Maturity risk premium = 2%
Default risk premium = 2.75%
On the basis of these data, what is the real risk-free rate of return? Round your answer to two decimal places.
%
Explanation / Answer
A) Yield on 2-year treasury = Real risk free rate + Average Inflation = 2.75% + (1.75% + 4%) / 2 = 5.63%
B) Yield on 3-year treasury = Real risk-free rate + Average inflation = 2.75% + (1.75% + 4% + 4%)/3 = 6.00%
C) Yield = Real rate + Average inflation + MRP = 2.85% + (2.2% + 4.6% + 2.15% x 4) / 7 + 0.05 x (7 - 1) = 5.35%
D) Corporate Bond Yield = Treasury Yield + Liquidity Premium + Default Premium
=> Default Premium = 8.5% - 6% + 0.55% = 1.95%
E) Yield = Real rate + Inflation + MRP
=> Maturity Risk Premium = 8.25% - 3.25% - 2% = 3.25%
F) For T-bills, liquidity, maturity and default risk premiums do not apply
Yield = Real rate + Inflation
=> Real risk-free rate = 4.8% - 2.5% = 2.30%