Use the following information to answer the next questions. Suppose the real ris

Question

Use the following information to answer the next questions.

Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity.

a) 3-year Treasury bond (as a percentage)
b) 20-year Treasury bond (as a percentage)
c) 1-year Treasury bond (as a percentage)
d) 1-year Corporate bond (as a percentage)

The value of MRP needed, but not already provided is
a) MRP = 4 x .10 (expressed in tenths of a percent)
b) MRP = 3 x .10 (expressed in tenths of a percent)
c) MRP = 2 x .10 (expressed in tenths of a percent)
d) MRP = 1 x .10 (expressed in tenths of a percent)

The yield on a 10-year treasury bond would be calculated as rT-bond equals
a) r* + IP + MRP
b) r* + IP + MRP + LP + DRP
c) r* + MRP + LP + DRP

(Enter the appropriate figures) Based on the calculation you selected above, the 1-year yield on a T-bond required is (Two decimals, %: 1.00 or 1.00%)
______________________________ % equals (Two decimals, %: 1.00 or 1.00%)
____________________________ % plus (Two decimals, %: 1.00 or 1.00%)_____________________
% plus (Two decimals, %: 1.00 or 1.00%)________________________%

Explanation / Answer

Solution:

a.

Real risk-free rate, r* = 3.00%

Inflation = 2.25%

MRP Years:3 Per year:0.10%*3 = 0.30%

Yield on 1-year T-bond = (1 + r*)(1 + I) – 1 + MRP

Yield on 1-year T-bond = (1.03) (1.0225) - 1 + 0.30% = 5.62%

b.

Real risk-free rate, r* = 3.00%

Inflation = 2.25%

MRP Years:3 Per year:0.10%*20 = 0.02%

Yield on 1-year T-bond = (1 + r*)(1 + I) – 1 + MRP

Yield on 1-year T-bond = (1.03) (1.0225) - 1 + 0.02% = 7.32%

c. Real risk-free rate, r* = 3.00%

Inflation = 2.25%

MRP Years:1 Per year:0.10%*1 = 0.10%

Yield on 1-year T-bond = (1 + r*)(1 + I) – 1 + MRP

Yield on 1-year T-bond = 5.2%

d. Corporate Bond Yield, r = r* + IP + MRP

Corprorate bond yield, r = 3.5% + 2.25% + 0.1%*(1 - 1)

Corprorate bond yield, r = 5.75%

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