Use excel in all of the problems. 4) The risk free rate of interest is 2.0%. Inf

Question

Use excel in all of the problems. 4) The risk free rate of interest is 2.0%. Inflation is expected to be 2.0% this year, 2.5% next year and 3% the following years. Assume the maturity risk premium is calculated to be 15% x (t-1); default risk premium is fixed at 1 .5% for years 1-5 and 2% for years 6-20,and liquidity premium is fixed at 0.5%. o) what ls beyveld on a 4 year bond? A 9 year bond? c) Currently, the price of energy products as fallen in the past year by 40%. According to our class discussions, could this security described above be a current Russian (Russia is heavily dependent on Oil) bond? Explain why or why not. Think in terms of how healthy the economy is and risk.

Explanation / Answer

a. r = real risk free rate+inflation premium+default risk premium+liquidity premium

risk free rate = 2.0%. Inflation premium = [0.02+0.025+0.03+0.03]/4 = 0.026250 or 2.625%

Maturity risk premium = 0.15%*(t-1) = 0.15%*(4-1) = 0.0045

Default risk premium = 1.5% and liquidity premium = 0.5%

Thus r = 2%+2.625%+0.45%+0.5%

= 5.575%

b. For a 9 year old bond, inflation premium = [0.02+0.025+(7*0.03)]/9 = 0.02833 or 2.8333%

Maturity risk premium = 0.15%*(t-1) = = 0.15%*(9-1) = 1.2%. Default risk premium = 2% and liquidity premium = 0.5%

Thus r = 2.8333%+1.2%+2%+0.5% = 6.533%

c. Here the economy is at great risk due to fall in the prices of energy products by a large quantum of 40%. This will make the default premium rise constantly in the background of falling prices of energy products. Here the default premium is fixed at 2% for years 6-20 and so this cannot be a current Russian bond.

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