Question

Question 1.)

One-year Treasury securities yield 4.55%. The market anticipates that 1 year from now, 1-year Treasury securities will yield 5.7%. 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.

Question 2.)

A Treasury bond that matures in 10 years has a yield of 5.25%. A 10-year corporate bond has a yield of 8.5%. Assume that the liquidity premium on the corporate bond is 0.75%. What is the default risk premium on the corporate bond? Round your answer to two decimal places.

Question 3.)

You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.7%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums:

Inflation premium = 3.25%

Liquidity premium = 0.7%

Maturity risk premium = 1.7%

Default risk premium = 2.45%

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

Question 4.)

The real risk-free rate is 3%. Inflation is expected to be 1.75% this year and 4.75% 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.

%

Answer 1

1) As per pure expectation theory, future rates are nothing but a representation of future short term rate of interest.

Thus, (1+r_2,0)^{^2} = (1+r_1,0)^{^1} * (1+r_1,1)^{^1}

(1+r_2,0)^{^2} = (1+0.0455)^{^1} * (1+0.057)^{^1}

(1+r_2,0)^{^2} = 1.1051

r_2,0 = 0.0512 = 5.12%

2) Corporate Bond Yield = T-Bond Yield + Liquidity Premium + Default Risk Premium

8.50% = 5.25% + 0.75% +DRP

DRP = 2.55%

3)short Term T-Bill Yield = real risk free rate of return + Inflation Premiun

5.70% = real risk free rate of return + 3.25%

real risk free rate of return = 2.45%

4) Using the formula: r = r* + IP + MRP

Yield on long term treasury security =  real risk-free rate + Average Inflation premium per annum + Maturity risk premium

For 2-years: Yield on treasury security = 3% + ((1.75%+4.75%)/2) + 0 = 6.25%

For 3-years: Yield on treasury security = 3% + ((1.75%+4.75%+4.75%)/3) + 0 = 6.75%