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 2.5% 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 x (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%. What is the yield on a 1-year bill? Round your intermediate calculations and final answer to two decimal places. What is the yield on a 5-year T-bond? Round your intermediate calculations and final answer to two decimal places. What is the yield on a 5-year corporate bond? Round your intermediate calculations and final answer to two decimal places.

Explanation / Answer

Solution:

b) Here, r* = 2.2%, IP = (2.1% + 3.1% + 4.1% + 5.1% + 5.1%)/5 = 3.90% and MRP = .1*(5-1)% = .4%

Using these values in the above formula, we get,

Yield on on a 5-year T-Bond (r5) = 2.2% + 3.90% + .4% = 6.50%

c) Here, r* = 2.2%, IP = (2.1% + 3.1% + 4.1% + 5.1% + 5.1%)/5 = 3.90%, MRP = .1*(5-1)% = .4%, DRP = 1% and LP = .5%

Using these values in the formula for Yield on Corporate Bond, we get,

Yield on Corporate Bond (r5) = 2.2% + 3.90% + .4% + 1% + .5% = 8%

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