Assume that an analyst has made the following forecasts: The real, risk-free rat

Question

Assume that an analyst has made the following forecasts: The real, risk-free rate is expected to remain constant at 2.85% for Inflation is expected to be as follows: Year 1-4.0%; Year 2-40%; The maturity risk premium is 0.10%(t-1), where t is the number of the next 10 years. Year 3-6.0%; Year 4-6.096; Year 5-8.06; and Year 6-8.0%. years to maturity. Also assume that you can buy a 6-year corporate bond for Company A today that yields an annual rate of return of 10.45%. Given this information, determine what the yield on a 5-year corporate bond from Company B should be if it has one half the default and liquidity premium as Company A. Answer in decimal format, to 4 decimal places. For example, if your answer is 25.22%, enter "0.2522".

Explanation / Answer

First we need to compute the default + liquidity premium of Company A.

Return = Real risk free rate + Average Inflation premium + Maturity risk premium + (default + liquidity premium)

For Company A

10.45% = 2.85%+ ((4%+4%+6%+6%+8%+8%)/6) + 0.1%*6 + default + liquidity premium

default + liquidity premium = 10.45%- 2.85% - 6%- 0.6% = 1%

Now for Company B

default + liquidity premium = ½ * 1% = 0.5%

So the Annual Return = 2.85%+ ((4%+4%+6%+6%+8%)/5) + 0.1%*5 + default + liquidity premium

= 2.85%+ ((4%+4%+6%+6%+8%)/5) + 0.1%*5 + 0.5%

= 9.45%

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