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End of Lecture Exercise 3

3

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14 views2 pages

End of Lecture Exercise 3

3

Uploaded by

Saaliha Saabira
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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END OF LECTURE EXERCISE 3

1. You are considering an investment in a one-year government debt security with a yield of 5
percent or a highly liquid corporate debt security with a yield of 6.5 percent. The expected
inflation rate for the next year is expected to be 2.5 percent.
  a. What would be your real rate earned on either of the two investments?
RF = RR + IP
Government bonds are risk free bonds and since information about other risk are not available
it will not be possible to use the Nominal rate formula.
Government debt rate = real rate + inflation premium
5% = x + 2.5%
2.5% = X
b. what would be the default risk premium on the corporate debt security, assuming maturity
risk premium and liquidity premium to be zero?
  r = RR + IP + DRP + MRP + LP
6.5 = 2.5 + 2.5+ X + 0 + 0
Default risk premium = 6.5% - 5% = 1.5%

2. Find the default risk premium for a debt security given the following information: inflation
premium = 3%, maturity risk premium = 2.5%, real rate = 3%, liquidity premium = 0%, and
the nominal interest rate is 10%.
r = RR + IP + DRP + MRP + LP
DRP = r – RR – IP – MRP – LP
DRP = 10% – 3% – 3% – 2.5% – 0% = 1.5%

3. A corporate bond has a nominal interest rate of 12 percent. This bond is not very liquid and
consequently requires a 2 percent liquidity premium. The bond is of low quality and thus has a
default risk premium of 2.5 percent. The bond has a remaining life of 25 years resulting in a
maturity risk premium of 1.5 percent.
r = RR + IP + DRP + MRP + LP
Treasury bond rate (TBR) = RR + IP
r = TBR + DRP + MRP + LP
A .Estimate the nominal interest rate on a Treasury bond.
TBR = r – DRP – MRP – LP = 12% – 2.5% – 1.5% – 2% = 6%
b. What would be the inflation premium on the Treasury bond if investors required a real rate
of interest of 2.5 percent?
IP = TBR – RR = 6% – 2.5% = 3.5%

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