Question

QUESTION 13 Assume that 1-year T-bills currently yield 5.00% and the future inflation rate is expected to be constant at 2.0% per year. What is the real risk-free rate of return, r"? 6.50% 5.00% 4 50% 4004 3.00% QUESTION 14 Suppose 10-year T-bonds have a yield of 4.00% and 10-year corporate bonds yield 6.50%. Also, corporate bonds have a 0.50% liquidity premium versus a zero iquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.20%. What is the default risk premium on corporate bonds? 1.50% 1.70% 2.00% 2.50 2.70% QUESTION 15 Suppose the interest rate on a 2 year T-bond is 0.0% and that on a 3-year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1 year rates 2 year from now? 7.750 8.10% 9.03% 10.03%

Answer 1

Question 13

Risk-free rate of return is the interest rate which one can expect from an absolutely risk-free investment over a given period of time. Real risk free return is risk free rate minus the inflation rate.

Thus, real risk free rate = Risk free rate (also called nominal rate) - inflation rate

Risk free rate (treasury yield)= 5%

Inflation rate - 2%

Real risk free rate = 5%-2% = 3%

Question 14

Risk free return - 4%

10 year corporate bond yield - 6.5%

Liquidity Premium - 0.5%

Maturity risk premium - 1.2%

Corporate bond yield = risk free rate + liquidity premium + default risk premium.

Substituing the value above in the formula,

6.5% = 4%+0.5%+x%

x% = 6.5%-4%-0.5% = 2%

Thus default risk premium is 2%

Question 15

Forward interest rate = ((1+7%)^3) / ((1+6%)^2)-1 = 9.028% or 9.03%