Question

An analyst evaluating securities has obtained the following information. The real rate of interest is 2.9% 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 answer to one decimal place.

_____ %

   b. What is the yield on a 5-year T-bond? Round your answer to one decimal place.

_____%

   c. What is the yield on a 5-year corporate bond? Round your answer to one decimal place.

_____%

Answer 1

a. What is the yield on a 1-year T-bill? Round your answer to one decimal place.

Yield = Real Interest rate + inflation premium

Yield = 2.90% + 2.10%

Yield = 5.0%

b. What is the yield on a 5-year T-bond? Round your answer to one decimal place.

yield on a 5-year T-bond = Real Interest Rate + Average Inflation + Maturity Premium

yield on a 5-year T-bond = 2.90% + (2.10%+3.10%+4.10%+5.10%+5.10%)/5 + 0.10 * (5-1)%

yield on a 5-year T-bond = 2.90% + 3.90% + 0.40%

yield on a 5-year T-bond = 7.2%

c. What is the yield on a 5-year corporate bond? Round your answer to one decimal place.

yield on a 5-year corporate bond = yield on a 5-year T-bond + Liquidity risk premium + default risk premium

yield on a 5-year corporate bond = 7.20% + 0.50%+1%

yield on a 5-year corporate bond = 8.7%