Question

Treasury securities that mature in 8 years currently have an interest rate of 8.0 percent. The maturity risk premium is estimated to be 0.1%(t - 1), where t is equal to the maturity of the bond (i.e., the maturity risk premium of a 1-year bond is zero). The real risk-free rate is assumed to be constant over time at 2%. For AAA rated 8-year bonds, DRP and LP combine to equal 2.5%. What is the expected rate of inflation (IP) over the next eight years?

Answer #1

Real Risk-free Rate = 2.00%

Maturity Risk Premium = 0.10% * (t - 1), t is number of years to
maturity

Maturity Risk Premium = 0.10% * (8 - 1)

Maturity Risk Premium = 0.70%

Sum of Default Risk Premium and Liquidity Premium = 2.50%

Interest Rate on Treasury Security = Real Risk-free Rate +
Inflation Premium + Maturity Risk Premium + Sum of Default Risk
Premium and Liquidity Premium

8.00% = 2.00% + Inflation Premium + 0.70% + 2.50%

8.00% = Inflation Premium + 5.20%

Inflation Premium = 2.80%

Therefore, expected rate of inflation over the next 8 years is 2.80%

A 6-year Treasury bond has an interest rate of 8.5 percent.
Inflation is expected to be 5 percent each of the next three years
and 6 percent each year after the third year. The maturity risk
premium is estimated to be 0.1%(t-1), where t is equal to the
maturity of the bond. The real risk-free rate is assumed to be
constant over time. What is the real risk-free rate of
interest?

Calculating interest rates
The real risk-free rate (r*) is 2.8% and is expected to remain
constant. Inflation is expected to be 7% per year for each of the
next four years and 6% thereafter.
The maturity risk premium (MRP) is determined from the formula:
0.1(t – 1)%, where t is the security’s maturity. The liquidity
premium (LP) on all Gauge Imports Inc.’s bonds is 1.05%. The
following table shows the current relationship between bond ratings
and default risk premiums (DRP):...

The real risk-free rate (r*) is 2.8% and is expected to remain
constant. Inflation is expected to be 5% per year for each of the
next two years and 4% thereafter.
The maturity risk premium (MRP) is determined from the formula:
0.1(t – 1)%, where t is the security’s maturity. The liquidity
premium (LP) on all Pandar Corp.’s bonds is 0.55%. The following
table shows the current relationship between bond ratings and
default risk premiums (DRP):
Rating
Default Risk Premium...

Problem 6-17
Interest Rate Premiums
A 5-year Treasury bond has a 4.65% yield. A 10-year Treasury
bond yields 6.1%, and a 10-year corporate bond yields 8.8%. The
market expects that inflation will average 2.85% over the next 10
years (IP10 = 2.85%). Assume that there is no maturity
risk premium (MRP = 0) and that the annual real risk-free rate, r*,
will remain constant over the next 10 years. (Hint: Remember that
the default risk premium and the liquidity premium...

The real risk-free rate (r*) is 2.8% and is expected to remain
constant. Inflation is expected to be 3% per year for each of the
next three years and 2% thereafter.
The maturity risk premium (MRP) is determined from the formula:
0.1(t – 1)%, where t is the security’s maturity. The liquidity
premium (LP) on all Rink Machine Co.’s bonds is 0.55%. The
following table shows the current relationship between bond ratings
and default risk premiums (DRP):
Rating
Default Risk...

A 5-year Treasury bond has a 3.5% yield. A 10-year Treasury bond
yields 6.4%, and a 10-year corporate bond yields 9%. The market
expects that inflation will average 3.3% over the next 10 years
(IP10 = 3.3%). Assume that there is no maturity risk
premium (MRP = 0) and that the annual real risk-free rate, r*, will
remain constant over the next 10 years. (Hint: Remember that the
default risk premium and the liquidity premium are zero for
Treasury securities:...

The real risk-free rate (r*) is 2.8% and is expected to remain
constant. Inflation is expected to be 6% per year for each of the
next five years and 5% thereafter.
The maturity risk premium (MRP) is determined from the formula:
0.1(t – 1)%, where t is the security’s maturity. The liquidity
premium (LP) on all National Transmissions Corp.’s bonds is 0.55%.
The following table shows the current relationship between bond
ratings and default risk premiums (DRP):
Rating
Default Risk...

A 5-year Treasury bond has a 3.25% yield. A 10-year Treasury
bond yields 6.1%, and a 10-year corporate bond yields 8.5%. The
market expects that inflation will average 2.1% over the next 10
years (IP10 = 2.1%). Assume that there is no maturity
risk premium (MRP = 0) and that the annual real risk-free rate, r*,
will remain constant over the next 10 years. (Hint: Remember that
the default risk premium and the liquidity premium are zero for
Treasury securities:...

A 5-year Treasury bond has a 4.05% yield. A 10-year Treasury
bond yields 6.8%, and a 10-year corporate bond yields 9.8%. The
market expects that inflation will average 2.55% over the next 10
years (IP10 = 2.55%). Assume that there is no maturity risk premium
(MRP = 0) and that the annual real risk-free rate, r*, will remain
constant over the next 10 years. (Hint: Remember that the default
risk premium and the liquidity premium are zero for Treasury
securities:...

A 5-year Treasury bond has a 4.6% yield. A 10-year Treasury bond
yields 6.7%, and a 10-year corporate bond yields 9.9%. The market
expects that inflation will average 2.4% over the next 10 years
(IP10 = 2.4%). Assume that there is no maturity risk
premium (MRP = 0) and that the annual real risk-free rate, r*, will
remain constant over the next 10 years. (Hint: Remember that the
default risk premium and the liquidity premium are zero for
Treasury securities:...

ADVERTISEMENT

Get Answers For Free

Most questions answered within 1 hours.

ADVERTISEMENT

asked 17 minutes ago

asked 42 minutes ago

asked 44 minutes ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 2 hours ago