Question

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 5-year Treasury securities or 5-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 5-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.

a. What is the fair interest rate on 5-year Treasury securities?

b. What is the fair interest rate on PeeWee Corporation 5-year bonds?

c. Plot the 5-year yield curve for the Treasury securities.

d. Plot the 5-year yield curve for the PeeWee Corporation bonds.

Answer 1

Pg No-0 is 1:35 •f. (lyr) Solution : Giver Data : - → Inflation premium → Inflation Premium → Inflation Premium → Inflation Premium is 15064 (2 yr) is 1.750%. (3 yu) is 2.4 [4 yr) • Real Risk free rates (lys) - 3,20% • Real Risk free rates (zyr): 3,301%. • Real Risk free sates (syy) = 3,75%. • Real Risk free rates (4 yo) = 3.80-4 → The following Information About Economin activity, and pewee Corporation 5-year Bonds :- • Maturity Risk Premium = 0,75%, • Liquidity risk Premium = 1.75.4. Default Risk Premium = 2,10 %

A). The fair interest rate on Pg No- Securities :- Prewet 5 years Treasury Inflation Rate Risk free rętevn Real Interest Year 1085 1:35 3.2 115 313 us we 1 1.45 3.75 348 3.8 Total of Real Interest = 1,85+118 +2+ 18+log 59.25 Average Rate = 9.25/5 - 1.85 :: Average rate = 1.85 B). The fair Interest Rate on Pee wee Corporation 5-year Bends - year Default Risk Premium Liquid Risk Bremina maturity Risk of Interest 2.1 11.75 0.75 46 1.75 0:1875 4.0375 0.1875 4,0375 1.75 0.1875 4:0375 1,75 0.1875 4.0375 1.75

Pg No-③ Real Interest = 4.6+ 4.0375 +4,0375 +400375 +4.0375 Total of - 20.75 The Average rate of Interest - 20:15 -4:15 | Rate of Interest = 4:15 () plot the 5-year yield Curve for the Treasury Securities : ben yield ő o s L 3 u s maturity. & Treasury Proved year yield curve for the precoce Comparatin bourals D plete the : Bands