You are considering an investment in a U.S. Treasury bond butyou are not sure wh

Question

You are considering an investment in a U.S. Treasury bond butyou are not sure what rate of interest it should pay. Assume thatthe real risk-free rate of interest is 1.0%; inflation is expectedto be 2.0%; the maturity risk premium is 1.5%; and, the defaultrisk premium for AAA rated corporate bonds is 3%. What rate ofinterest should the U.S. Treasury bond pay?
a. 7.5% b. 4.5% c. 3.5% d. 3.0% You are considering an investment in a U.S. Treasury bond butyou are not sure what rate of interest it should pay. Assume thatthe real risk-free rate of interest is 1.0%; inflation is expectedto be 2.0%; the maturity risk premium is 1.5%; and, the defaultrisk premium for AAA rated corporate bonds is 3%. What rate ofinterest should the U.S. Treasury bond pay?
a. 7.5% b. 4.5% c. 3.5% d. 3.0%

Explanation / Answer

K        =          requiredreturn (or) yield on debt security

K*       =          realrisk-free rate of interest

IP       =          Inflationpremium

DRP   =          defaultrisk premium

LP      =          liquiditypremium

MRP   =          maturityrisk premium

Real Risk-free rate of interest(K*) = 1.0%

Expected Inflation (IP) = 2.0%

Maturity Risk Premium (MRP) = 1.5%

Default Risk Premium (DRP) = 3%

K = K*+IP+DRP+LP+MRP

K = 1.0% + 2.0% + 3% + 0 + 1.5%

K = 7.5%

Interest rate on U.S Treasury Bond (K)= 7.5%

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