Question

EXPECTATIONS THEORY

One-year Treasury securities yield 3.65%. The market anticipates that 1 year from now, 1-year Treasury securities will yield 5.55%. If the pure expectations theory is correct, what is the yield today for 2-year Treasury securities? Calculate the yield using a geometric average. Do not round your intermediate calculations. Round your answer to two decimal places.

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EXPECTED INTEREST RATE

The real risk-free rate is 2.45%. Inflation is expected to be 3.25% this year, 3.6% next year, and 2.2% thereafter. The maturity risk premium is estimated to be 0.05 × (t - 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? Do not round your intermediate calculations. Round your answer to two decimal places.

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DEFAULT RISK PREMIUM

The real risk-free rate, r*, is 3.15%. Inflation is expected to average 1.8% a year for the next 4 years, after which time inflation is expected to average 2.55% a year. Assume that there is no maturity risk premium. An 8-year corporate bond has a yield of 11.6%, which includes a liquidity premium of 0.3%. What is its default risk premium? Do not round intermediate calculations. Round your answer to two decimal places.

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Answer 1

EXPECTATIONS THEORY: 2 year treasury securities = ((1+0.0365)*(1+0.0555))^(1/2) -1 = 0.04595 = 4.595% = 4.60%(Rounded to 2 decimals)

EXPECTED INTEREST RATE: Expected interest rate of T-note = real risk free rate + Inflation premium + maturity risk premium

Average inflation = ( 3.25+3.6 + 2.2*5)/7 = 2.55%

matruity risk premium = 0.05*(t-1) =0.05*(7-1) =0.3%

Expected interest rate = 2.45+2.55+0.3 = 5.30%

DEFAULT RISK PREMIUM (DRP)

Expected yield = r* + IP + LRP + DRP

Expected yield = 11.6%

r* =3.15%

IP = (1.8*4 + 2.55*4)/8 = 2.175%

LRP = 0.3%

11.6% = 3.15% + 2.175% + 0.3% + DRP

DRP = 11.6-3.15-2.175-0.3 = 5.975%

Default risk premium = 5.98% (rounded to 2 decimals)