For every question, please write down each main step before you obtain the final
ID: 2618719 • Letter: F
Question
For every question, please write down each main step before you obtain the final answer. Correct final answer with incorrect related work (calculation) or without any work may receive 0 point. On the contrary, incorrect final answer with correct related work (calculation) will receive partial credits.
Question 4 – MRP and DRP [6 points]: Suppose that today’s Wall Street Journal reports the yield on Treasury bills maturing in 30 days is 4 percent, the yield on Treasury bonds maturing in 10 years is 6 percent, and the yield on a bond issued by Nextel Communications that matures in six years is 7 percent. Also, today the Federal Reserve announced that inflation is expected to be 2.0 percent during the next 12 months. There is a maturity risk premium (MRP) associated with all bonds with maturities equal to one year or more. Assume Nextel’s bond is very liquid, and thus it has no liquidity premium.
Assume that the increase in the MRP each year is the same and the total MRP is the same for bonds with maturities equal to 10 years and greater — that is, MRP is at its maximum for bonds with maturities equal to 10 years and greater. What is the MRP per year?
What is the default risk premium associated with Nextel’s bond.
What is the real-risk free rate of return?
Explanation / Answer
* Maturity risk Premium= 10 year Treasury Bond yield- one year Treasury Bond Yield
=6%- 4%= 2% or .02
* Default Risk Premium= Treasury Bonds annual rate of return- risk free premium- inflation premium- liquidity premium
= 7%- 4%- 2%- 0
=1%
* Real risk free rate of return= 4%- 2%
= 2%
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