Question

An analyst evaluating securities has obtained the following information. The real rate of interest is 2.3% 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.
  %

Answer 1

1)Yield on a 1-year T-bill = Risk free rate +inflation premium

                   = 2.3+2.1

                   = 4.4%

2) yield on a 5-year T-bond = Risk free rate+ average inflation for 5 years+ maturity risk premium

                       = 2.3 +3.9+.4

                      = 6.60%

**Average inflation for 5 years = [2.1+3.1+4.1+5.1+5.1]/5

                       = 19.5/5

                        = 3.9%

maturity risk premium = .1* (t-1) %

                         = .1 * (5-1)%

                         = .1 *4

                          = .4%

3) yield on a 5-year corporate bond = Risk free rate+ average inflation for 5 years+ maturity risk premium+ default risk premium +liquidity premium

          = 2.3 +3.9+.4 + 1+.5

          = 8.1%