Question

The real risk-free rate of interest, is 3%, and it is expected to remain constant over time. Inflation is expected to be 2% per year for the next 3 years and 4% per year for the next 5 years. The maturity risk premium is equal to 0.1 x (t-1) %, where t = the bond’s maturity. The default risk premium for a BBB-rated bond is 1.3%.

a- What is the average expected inflation rate over the next 4 years?

b-What is the yield on a 4-year Treasury bond?

c-What is the yield on a 4-year BBB-rated corporate bond with a liquidity premium of 0.5%?

d-What is the yield on an 8-year Treasury bond?

e-What is the yield on an 8-year BBB-rated corporate bond with a liquidity premium of 0.5%?

Answer 1

1.
=(2%*3+4%)/4
=2.50%

2.
=real risk free rate+inflation+maturity risk premium
=3%+(2%*3+4%)/4+0.1*(4-1)%
=5.80%

3.
=yield on Treasury bond+liquidity premium+default risk premium
=5.80%+0.50%+1.3%
=7.60%

4.
=3%+(2%*3+4%*5)/8+0.1*(8-1)%
=6.95%

5.
=6.95%+0.5%+1.3%
=8.75%