Question

In: Finance

From discussions with your broker, you have determined that the expected inflation premium is 1.35 percent...

From discussions with your broker, you have determined that the expected inflation premium is 1.35 percent next year, 1.50 percent in year 2, 1.75 percent in year 3, and 2.00 percent in year 4 and beyond. Further, you expect that real risk-free rates will be 3.20 percent next year, 3.30 percent in year 2, 3.75 percent in year 3, and 3.80 percent in year 4 and beyond. You are considering an investment in either five-year Treasury securities or five-year bonds issued by PeeWee Corporation. The bonds have no special covenants. Your broker has determined the following information about economic activity and PeeWee Corporation five-year bonds:

Default risk premium = 2.10%

Liquidity risk premium = 1.75

Maturity risk premium = 0.75

Further, the maturity risk premium on PeeWee bonds is 0.1875 percent per year starting in year 2. PeeWee’s default risk premium and liquidity risk premium do not change with bond maturity.

  1. What is the fair interest rate on five-year Treasury securities?
  2. What is the fair interest rate on PeeWee Corporation five-year bonds?
  3. Plot the five-year yield curve for the Treasury securities.
  4. Plot the five-year yield curve for the PeeWee Corporation bonds.

Solutions

Expert Solution

a. What is the fair interest rate on five year treasury security?

Sol:- As treasury security is being issued by the government, there is no default risk because in finance we believe that government can not default, as they have the ability to print the currency and repay the debt.

Liquidity premium is the overhead charged by the issuer if the instrument is not very liquid or do not get converted in to cash very frequently at its fair value, so the investor asks for the additional premium to compensate this loss.

based on the data given in the above question:

Face value $100
Default risk premium 2.10%
Liquidity risk premium 1.75%
Maturity risk premium 0.75%

Following are the required calculation to get the desired data:-

Year 1 2 3 4 5
Inflation Premium 1.35% 1.50% 1.75% 2% 2%
Real Risk free rates 3.20% 3.30% 3.75% 3.80% 3.80%
Liquidity risk premium 1.75% 1.75% 1.75% 1.75% 1.75%
Maturity risk premium 0.75% 0.75% 0.75% 0.75% 0.75%
Fair Interest Rate(Addition) 7.05% 7.30% 8.00% 8.30% 8.30%
Future Value 107.05 115.13 125.97 137.57 148.98

YTM =8.30%

b. What is the fair interest rate on Pee Wee Corporation five year bonds?

Soln:-

Face value $100 Assumption
Default risk premium 2.10%
Liquidity risk premium 1.75%
Maturity risk premium 0.75%

Calculation of fair interest rate

Year 1 2 3 4 5
Inflation Premium 1.350% 1.500% 1.750% 2.000% 2.000%
Real Risk free rates 3.200% 3.300% 3.750% 3.800% 3.800%
Liquidity risk premium 1.750% 1.750% 1.750% 1.750% 1.750%
Maturity risk premium 0.750% 0.188% 0.188% 0.188% 0.188%
Default risk premium 2.100% 2.100% 2.100% 2.100% 2.100%
Fair Interest Rate 9.150% 8.838% 9.538% 9.838% 9.838%
Future Value 109.15 118.46 131.43 145.55 159.86

YTM will be 9.84%

c. Five year Yield curve of treasury security.

Soln:-

Year 1 2 3 4 5
YTM 7.05% 6.74% 7.44% 7.74% 7.74%

c. Five year Yield curve of PeeWee Corporation

Year 1 2 3 4 5
YTM 9.15% 8.84% 9.54% 9.84% 9.84%

.

jeff jeffy answered 7 months ago
Next > < Previous

Related Solutions

From discussions with your broker, you have determined that the expected inflation premium is 1.35 percent...
From discussions with your broker, you have determined that the expected inflation premium is 1.35 percent next year, 1.50 percent in year 2, 1.75 percent in year 3, and 2.00 percent in year 4 and beyond. Further, you expect that real risk-free rates will be 3.20 percent next year, 3.30 percent in year 2, 3.75 percent in year 3, and 3.80 percent in year 4 and beyond. You are considering an investment in either five-year Treasury securities or five-year bonds...
2. A stock has a beta of 1.35, the market risk premium is 6 percent, and...
2. A stock has a beta of 1.35, the market risk premium is 6 percent, and the risk-free rate is 3.5 percent. What is the required rate of return on this stock? Group of answer choices a. 3.50% b. 6.87% c. 11.60% d. 13.13%
Which of the following statements is true? a “Inflation premium” is the amount that the interest rate is raised to cover the effects of anticipated inflation. The “inflation premium” is the expected rate of inflation
Question 37 (1 point) Which of the following statements is true? a “Inflation premium” is the amount that the interest rate is raised to cover the effects of anticipated inflation. The “inflation premium” is the expected rate of inflation. b (Ex-ante) “Real interest rate” is defined as the nominal interest rate minus the “inflation premium”. c In the past, deflation has been as much a problem as inflation. d All of the above. e Only a) and b) Question 38...
You have determined the following data for a given bond: Real risk-free rate (r*) = 3%; inflation premium = 8%; default risk premium = 2%; liquidity premium = 2%; and maturity risk premium = 1%.
You have determined the following data for a given bond: Real risk-free rate (r*) = 3%; inflation premium = 8%; default risk premium = 2%; liquidity premium = 2%; and maturity risk premium = 1%.What is the interest rate on short-term Treasury securities, or T-bills, of the relevant maturity?What is the interest rate on long-term corporate bonds, of the relevant maturity?
How is the inflation premium and risk premiums determined? I understand that the liquidity risk and...
How is the inflation premium and risk premiums determined? I understand that the liquidity risk and maturity risk make up the risk premium, but how are these things determined, and who decides them?  
Stock J has a beta of 1.35 and an expected return of 13.91 percent, while Stock...
Stock J has a beta of 1.35 and an expected return of 13.91 percent, while Stock K has a beta of .90 and an expected return of 10.85 percent. You want a portfolio with the same risk as the market. What is the portfolio weight of each stock? (Do not round intermediate calculations and round your answers to 4 decimal places, e.g., 32.1616.)    Stock J Stock K    What is the expected return of your portfolio? (Do not round...
10. If the nominal interest rate is 7 percent and expected inflation is 4.5 percent, then...
10. If the nominal interest rate is 7 percent and expected inflation is 4.5 percent, then what is the expected real interest rate? A. 11.5 percent B. 7.0 percent C. 4.5 percent D. 2.5 percent E. less than 2.5 percent 11. Which of the following statements is (are) correct? (x) In the U.S., from the early 1980s through the early 1990s, both inflation and nominal interest rates fell. (y) If a country had deflation, the nominal interest rate would be...
A. In discussions with your bank manager, you have been offered a 20 year mortgage with...
A. In discussions with your bank manager, you have been offered a 20 year mortgage with interest rates fixed for the next 5 years at 4.5% (when the rates will be reset), or an alternative of a mortgage with interest rates fixed over the whole term of the mortgage at a rate of 5.5%. Explain why you might not want to take advantage of the lower rates on the 5 year fixed option
From a truly free market/capitalist perspective, how is inflation a beneficial process (our myriad discussions on...
From a truly free market/capitalist perspective, how is inflation a beneficial process (our myriad discussions on this concept and the supplemental readings will be very        helpful here)?
The U.S. inflation rate is expected to be 3 percent over thenext year, while the...
The U.S. inflation rate is expected to be 3 percent over the next year, while the European inflation rate is expected to be 1.25 percent. The current spot rate of the euro is $1.19. Using purchasing power parity, the expected spot rate at the end of one year is $____.1.191.201.211.22
ADVERTISEMENT
Subjects
ADVERTISEMENT
Latest Questions
ADVERTISEMENT