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Suppose the inflation rate is expected to be 2% next year, 3% the following year, and...

Suppose the inflation rate is expected to be 2% next year, 3% the following year, and 5% thereafter. Assume that the real risk free rate will remain constant at 1% and that MRP = (0.25x(t-1))% where t is the number of years to maturity. The default risk premium on 5 year corporate bonds is 0.75% and the liquidity premium on 5 year corporate bonds is 0.25%.

a. Calculate the interest rate on a 5 year treasury security.

b. Calculate the interest rate on a 5 year security.
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Answer #1

Inflation Rate for 5 years = [2% + 3% + (5% * 3)] / 5 = 20% / 5 = 4%

a). 5-year T-Sec. Yield = Real Risk-free Rate + Inflation Rate + MRP

= 4% + 1% + [0.25 * (5 - 1)%]

= 5% + 1% = 6%

b). 5-year Security Yield = Real Risk-free Rate + Inflation Rate + MRP + DRP + LP

= 4% + 1% + [0.25 * (5 - 1)%] + 0.75% + 0.25%

= 6% + 1% = 7%

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