Question

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 2.4% next year, 3.4% the following year, 4.4% the third year, and 5.4% 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 1

1.
=real rate+inflation
=2.7%+2.4%
=5.1%

2.
=real rate+inflation+maturity risk premium
=2.7%+(2.4%+3.4%+4.4%+2*5.4%)/5+0.1*(5-1)%
=7.300%

3.
=yield on 5 year Tbond+default risk premium+liquidity premium
=7.3%+1%+0.5%
=8.8%