1. 11. (3 points) A Treasury bill has a yield of 2.3%. A Treasury bond that matu

Question

1. 11. (3 points) A Treasury bill has a yield of 2.3%. A Treasury bond that matures in 5 years has a yield of 3.5%. A 5-year BB corporate bond has a yield of 6.8%. Assume that the default risk premium on the corporate bond is 3% and that the inflation premium is expected to remain constant over time.

a.     What is the interest rate risk premium on a 5-year bond?

b.     What is the spread on the 5-year BB corporate bond?

c.     What is the liquidity premium on the 5-year BB corporate bond?

2. 2. (2 points) What is price risk? Create an example to illustrate the fact that long-term bonds are more sensitive to price risk than are short-term bonds, all else equal. Your example must use different numbers than those presented in class and the textbook.

Explanation / Answer

a) interest rate risk premium on a 5-year bond = 3.5 - 2.3 = 1.2

b) spread = 3%

c) liquidity premium = 6.8% - 3.5% = 3.3%

Price risk is simply the risk that the price of a security will fall.

For example, assume that Company XYZ is trading at $4 per share. The company is stable and doing well, but there is some uncertainty in the market about Company XYZ's new model of widget that it coming out next year , and the economy looks like it's headed for a recession .There is no certainty that the price of Company XYZ will stay at $4 per share or rise above $4, and thus investors in Company XYZ bear price risk when they hold the stock

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