An analyst evaluating securities has obtained the following information. The rea

Question

An analyst evaluating securities has obtained the following information. The real rate of interest is 3% and is expected to remain constant for the next 5 years. Inflation is expected to be 2.1% next year, 3.1% the following year, 4.1% the third year, and 5.1% 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.
  %

Explanation / Answer

We have:

R*= 3%

Mrp = 0.1x(t-1)%

LP= 0.5%

DRP = 1%

We have the following formula for yield on treasury Bond:

R= R*+MRP + LP + IP

R= 3% +0.10x(1-1)% + 0.5%++2.1%

R = 3%+0+0.5%+1%+2.1%

R= 5.60%

b)

R= R*+MRP + LP + IP

R= 3% +0.10x(5-1)% + 0.5%+1%+(2.1% +3.1%+4.1%+5.1%+5.1%)/5

R = 3%+0.4%+0.5%+3.90%

R= 7.80%

c) Yield on corporate bond:

Yield on corporate bond = yield on Treasury bond + DRP

                                                = 7.80% +1%

                                                = 8.80%

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