Question

The real risk free rate r* is 0.3%. The expected inflation rate is 2% this year, 3% next year and 3.5% the year after that. The DRP and LP for a corporate bond are 1% and 2% respectively. The MRP is can be found using the equation 0.2*(t-1)%, where t is the number of years to maturity.

a. Find the yield on a 1-year corporate bond.

b. Find the yield on a 2-year Treasury bond.

c. Find the yield on a 3-year corporate bond.

Answer 1

r = r* + IP + MRP + DRP + LP

r* = Real risk free rate

IP = Inflation Premium

MRP = Maturity Risk Premium

DRP = Default Risk Premium

LP = Liquidity Premium

r* = 0.3%

Part A:

r* = 0.3%

IP = 2%

MRP = 0.2 * (1 - 1)% = 0%

DRP = 1%

LP = 2%

r = 0.3% + 2% + 0% + 1% + 2%

r = 5.3%

Part B:

r* = 0.3%

IP = (2% + 3%)/ 2 = 2.5%

MRP = 0.2 * (2 - 1)% = 0.2%

DRP = 1%

LP = 2%

r = 0.3% + 2.5% + 0.2% + 1% + 2%

r = 6.0%

Part C:

r* = 0.3%

IP = (2% + 3% + 3.5%)/ 3 = 2.83%

MRP = 0.2 * (3 - 1)% = 0.4%

DRP = 1%

LP = 2%

r = 0.3% + 2.83% + 0.4% + 1% + 2%

r = 6.53%