Question

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You are given the following interest rate data:

90-day Treasury Bills 3%

20-year Treasury Bonds 5%

20-year AT&T Corporate Bonds 10%

Expected annual inflation rate 2 %

(1) The real interest rate is _______%

(2) The maturity risk premium is _____%

(3) The default risk premium of AT&T corporate bond is ______%

(4) If the expected annual inflation rate increases to 3%, the 90-day T-bill interest rate should be _____%; and the interest rate of 20-year AT& corporate bond should be ______%.

Answer 1

Q1) 1%

Explanation: Real interest rate = nominal interest rate - inflation rate

= 3% - 2%

= 1%

Q2) 2%

Explanation: Maturity risk premium= 20-year Treasury bonds - 90 days T-bill

= 5% - 3%

= 2%

Q3) 5%

Explanation: Default risk premium= 20 year corporate bond - 20 year treasury bond

= 10% - 5%

= 5%

Q4) 4% , 11%

Explanation: New interest rate = real interest rate + new inflation rate

= 1% + 3%

= 4%

20 year corporate bond = 10% + 1% (difference in inflation is 1%)

= 11%