EBK CFIN
6th Edition
ISBN: 9781337671743
Author: BESLEY
Publisher: CENGAGE LEARNING - CONSIGNMENT
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Chapter 5, Problem 12PROB
Summary Introduction
Risk free rate:
Interest rate which has no risk of loss. For risk free rate risk is zero.
Calculate the forward risk free rate as follows:
Given one year inflation rate is 1.4%, year two inflation rate is 1.8% and 2% after year 2. Assume the real risk free rate is 3%.
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The rate of inflation for the next 12 months (Year 1) is expected to be 1.4 percent; it is expected to be 1.8 percent the following year (Year 2); and it is expected to be 2.0 percent every year after Year 2. Assume the real risk-free, r*, is 3 percent for all maturities. What should be the yield to maturity on risk-free bonds that mature in (a) one year, (b) five years, and (c) 10 years.
The real risk-free rate of interest, r*, is 4 percent, and it is expected to remain constant over time. Inflation is expected to be 2 percent per year for the next three years, after which time inflation is expected to remain at a constant rate of 5 percent per year. The maturity risk premium is equal to 0.1(t - 1)%, where t = the bond’s maturity. What is the yield on a 10-year Treasury bond?
Assume that the real risk-free rate of return, k*, is 3%, and it will remain at that level far into the future. Also assume that maturity risk premiums (MRP) increase from zero for bonds that mature in one year or less to a maximum of 1%, and MRP increases by 0.2% for each year to maturity that is greater than one year-that is, MRP equals 0.2% for two-year bond, 0.4% for a three-year bond, and so forth. Following are the expected inflation rates for the next five years:
Year
Inflation Rate (%)
2017
5
2018
6
2019
7
2020
8
2021
9
a) Compute the interest rate for a one-, two-, three-, four-, and five-year bond.
b) If inflation is expected to equal 9% every year after 2021, what should be the interest rate for a 10- and 20-year bond?
c) Plot the yield curve for the interest rates you computed in part [a] and [b].
d) Based on the curve (in part c), interpret your findings.
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- Suppose the yield on a two-year-old Treasury bond is 5 percent and the yield on a one-year Treasury bond is a 4 percent. If the maturity risk premium (MRP) on these bonds is zero (0), what is the expected one-year interest rate during the second year (Year 2)?arrow_forwardSuppose you are considering two possible investment opportunities: a 12-yearTreasury bond and a 7-year, A-rated corporate bond. The current real risk-free rateis 4%, and inflation is expected to be 2% for the next 2 years, 3% for the following4 years, and 4% thereafter. The maturity risk premium is estimated by this formula:MRP = 0.02(t - 1)%. The liquidity premium (LP) for the corporate bond is estimatedto be 0.3%. You may determine the default risk premium (DRP), given thecompany’s bond rating, from the table below. Remember to subtract the bond’s LPfrom the corporate spread given in the table to arrive at the bond’s DRP. Whatyield would you predict for each of these two investments?RateCorporate Bond Yieldarrow_forwardConsider a 10-year bond with current price of $98.4 and a duration of 9.1 years. Suppose the yield on the bond is 9.6% per year with continuous compounding. What is the predicted change in the price (in dollars) of the bond if the yield increases by 0.4%? (required precision: 0.01 +/- 0.01)arrow_forward
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- The real risk-free rate of interest, k* is 3 percent. Inflation is expected to be 4 percent this year, 5 percent next year, and 3 percent per year thereafter. The maturity risk premium equals 0.1% (t - 1), where t equals the bond's maturity. That is a 5-year bond has a maturity risk premium of 0.4 percent. A 5-year corporate bond yields 8 percent. What is the yield on a 10-year corporate bond that has the same default risk and liquidity premium as the 5 -year corporate bond?arrow_forwardTreasury securities that mature in 6 years currently have an interest rate of 7.75 percent. Inflation is expected to be 5 percent in each of the next three years and 6 percent each year thereafter. The maturity risk premium is estimated to be 0.10% × (t – 1), where t is equal to the maturity of the bond (i.e., the maturity risk premium of a one-year bond is zero). The real risk-free rate is assumed to be constant over time. What is the real risk-free rate of interest? Group of answer choices 3.00% 1.75% 1.00% 2.50%arrow_forwardSuppose that you buy a two-year 8% bond at its face value. a. What will be your total nominal return over the two years if inflation is 3% in the first year and 5% in the second? b. What will be your total real return?arrow_forward
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