Question

You read in The Wall Street Journal that 30-day T-bills are currently yielding 4.5%. Your brother-in-law,...

You read in The Wall Street Journal that 30-day T-bills are currently yielding 4.5%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums:

  • Inflation premium = 3.00%
  • Liquidity premium = 0.6%
  • Maturity risk premium = 2.00%
  • Default risk premium = 2.00%

On the basis of these data, what is the real risk-free rate of return? Round your answer to two decimal places.

The real risk-free rate is 2.25%. Inflation is expected to be 2.50% this year and 5.00% during the next 2 years. Assume that the maturity risk premium is zero.

What is the yield on 2-year Treasury securities? Do not round intermediate calculations. Round your answer to two decimal places.

  %

What is the yield on 3-year Treasury securities? Do not round intermediate calculations. Round your answer to two decimal places.

  %

Homework Answers

Answer #1

(a)

REAL RISK FREE RATE OF RETURN = 1.5%

  • T-bill yield = 4.5%
  • inflation premium = 3.00%
  • Liquidity premium = 0.6%
  • Maturity risk premium = 2.00%
  • Default risk premium = 2.00%

t - bill yield = risk free rate + inflation premium

4.5% = risk free rate + 3%

risk free rate =1.5%

(b)

real risk free rate = 2.25%

inflation premium = 2.5% (this year) ; 5% (next 2 years)

maturity risk premium = 0%

t- bill yield = risk free rate + inflation premium + market risk premium

average inflation (IP2) = 2.5% + 5% / 2 = 3.75%

average inflation (IP3) = 2.5% + 5% + 5% / 3 = 4.167%

yield on 2 year tresury (T2) =

t bill yield (T2) = risk free rate + inflation premium + market risk premium

= 2.25% + 3.75% + 0

= 6%

yield on 3 year tresury (T3) =

t bill yield (T3) = risk free rate + inflation premium + market risk premium

= 2.25% + 4.167% + 0

= 6.417%

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