An analyst evaluating securities has obtained the following information. The real rate of interest is 2.7% and is expected to remain constant for the next 5 years. Inflation is expected to be 2.5% next year, 3.5% the following year, 4.5% the third year, and 5.5% every year thereafter.

An analyst evaluating securities has obtained the following information. The real rate of interest is 2.7% and is expected to remain constant for the next 5 years. Inflation is expected to be 2.5% next year, 3.5% the following year, 4.5% the third year, and 5.5% every year thereafter. The maturity risk premium is estimated to be 0.1 × (t – 1)%, where t = number of years to maturity. The liquidity premium on relevant 5-year securities is 0.5% and the default risk premium on relevant 5-year securities is 1%.

a. What is the yield on a 1-year T-bill? Round your intermediate calculations and final answer to two decimal places. %

b. What is the yield on a 5-year T-bond? Round your intermediate calculations and final answer to two decimal places. %

c. What is the yield on a 5-year corporate bond? Round your intermediate calculations and final answer to two decimal places. %

 

 

answer:

a. Yield on 1 year T-bill = real risk free rate of interest = 2.7%. As number of years to maturity is 1 here there will be no maturity risk premium applicable here. Hence the yield on 1 year T-bill will be 2.70%.

b. Yield on 5 year T-bond = real risk free rate+average inflation of 5 years+maturity risk premium

real risk free rate = 2.7% (as given). average inflation = sum of inflation rates/5 = (2.5+3.5+4.5+5.5+5.5)/5 = 4.3%. Maturity risk premium = 0.1*(5-1)% = 0.4%.

Thus yield = 2.7%+4.3%+0.4%

= 7.40%

c. Yield on a 5 year corporate bond = yield on a 5 year T bond+liquidity premium+default risk premium

= 7.4%+0.5%+1%

= 8.90%

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