Question

ut of A particular security's default risk premium is 3 percent. For all securities, the inflation risk premium is 2 percent and the real interest rate is 2.25 percent. The security's liquidity risk premium is 0.75 percent and maturity risk premium is 0.90 percent. The security has no special covenants. What is the security's equilibrium rate of return? O Select one: A. 1.78 percent B . 17.8 percent C. 8.90 percent D. 3.95 percent The Wall Street Journal reports that the rate on three- year Treasury securities is 3.25 percent and the rate on four-year Treasury securities is 3.00 percent. Thus, according to the unbiased expectations hypothesis, the market expects the one-year Treasury rate to be approximately three years from today. - Select one: a. 3.50 percent b. 2.25 percent c. 2.50 percent d. 3.75 percent

Answer 1

1]

Equilibrium rate of return = real risk free rate + inflation risk premium + default risk premium + liquidity risk premium + maturity risk premium

Equilibrium rate of return = 2.25% + 2% + 3% + 0.75% + 0.90%

Equilibrium rate of return = 8.90%

2]

As per expectations theory, investing for 4 years at the 4-year rate should result in the same ending value as investing for 3 year at the 3-year rate, and reinvesting the proceeds after 3 years at the 1-year rate 3 years from now.

Let us say the 1-year rate 3 years from now is R. Then :

(1 + 3.00%)4 = (1 + 3.25%)3 * (1 + R)

R = (1.034 / 1.03253) - 1

R = 2.25%