Question

1.) Kay Corporation's 5-year bonds yield 6.30% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the default risk premium for Kay's bonds is DRP = 1.30% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) × 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Kay's bonds?

a. 0.36%

b. 0.41%

c. 0.45%

d. 0.50%

e. 0.60%

2.) McCue Inc.'s bonds currently sell for $1,100. They pay a $90 annual coupon, have a 25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,070. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond's YTM and its YTC?

a. 1.22%

b. 1.13%

c. 0.97%

d. 0.66%

e. 0.35%

Answer 1

1). Yield = Real rF + Inflation RP + Default RP + Maturity RP + Liquidity Premium

6.3% = 2.5% + 1.5% + 1.3% + [(5 - 1) x 0.1%] + Liquidity Premium

Liquidity Premium = 6.3% - 2.5% - 1.5% - 1.3% - 0.4% = 0.6%

Hence, Option "e" is correct.

2). To find the YTM, we need to put the following values in the financial calculator:

INPUT	25		-1,100	90	1,000
TVM	N	I/Y	PV	PMT	FV
OUTPUT		8.06

Hence, YTM = 8.06%

To find the YTC, we need to put the following values in the financial calculator:

INPUT	5		-1,100	90	1,070
TVM	N	I/Y	PV	PMT	FV
OUTPUT		7.71

Hence, YTC = 7.71%

Difference = 8.06% - 7.71% = 0.35%

Hence, Option "e" is correct.