1. A particular security’s equilibrium rate of return is 8 percent.

For all securities, the inflation

risk premium is 1.75 percent and the real risk-free rate is 3.5 percent. The security’s
liquidity risk premium is 0.25 percent and maturity risk premium are 0.85 percent. The
security has no special covenants. Calculate the security’s default risk premium.

Answer:

The fair interest rate on a financial security is calculated as:

r = r* + IP + RFR + DRP + MRP

8% = 1.75% + 3.5% + DRP + 0.25% + 0.85%

DRP = 8% - 1.75% - 3.5% - 0.25% - 0% - 0.85%

DRP = 1.65%

2. Dakota Corporation 15-year bonds have an equilibrium rate of return of 8 percent. For all
securities, the inflation rate is 3.50 percent. The security’s liquidity risk premium is 0.25
percent and maturity risk premium are 0.85 percent. The security has no special
covenants. Calculate the bond’s default risk premium.

Answer:

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

8% = 3.50% + DRP + .25% + .85%

DRP= 8% - (3.50% + .25% + .85%)

DRP = 3.40 %

3. Tom and Sue’s Flowers Inc.’s 15-year bonds are currently yielding a return of 8.25 percent.
The expected inflation premium is 2.25 percent annually and the real risk-free rate is
expected to be 3.50 percent annually over the next 15 years. The default risk premium on
Tom and Sue’s Flowers’ bonds is 0.80 percent. The maturity risk premium is 0.75 percent
on 5-year securities and increases by 0.04 percent for each additional year to maturity.
Calculate the liquidity risk premium on Tom and Sue’s Flowers Inc.’s 15-year bonds.

Answer:

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

.25% = 2.25% + 3.50% + 0.80 +
LRP + (0.75% + (0.04% x 10))
=> LRP = 8.25% - (2.25% +
3.50% + 0.80% + (0.75% + (0.04% x
10))) = 0.55
4. The current one-year Treasury-bill rate is 5.2 percent and the expected one-year rate 12
months from now is 5.8 percent. According to the unbiased expectations theory, what
should be the current rate for a two-year Treasury security?

Answer:

1R2 = [(1 + 1R1) (1 + E(2r1))]1/2 – 1

0.052 = [(1 + 0.058) (1 + E(2r1))] ½ - 1

(1.052)2 = (1.058) (1 + E(2r1))

1.106704 = 1 + E(2r1))

1.058

1.0460 - 1 = E(2r1))

E(2r1)) = 4.60

5. One-year Treasury bills currently earn 3.45 percent. You expect that one year from now,
one-year Treasury bill rates will increase to 3.65 percent. If the unbiased expectations
theory is correct, what should the current rate be on two-year Treasury securities?

Answer:

1R2 = [(1 + 1R1) (1 + E(2r1))]1/2 – 1

0.0345 = [(1 + 0.0365) (1 + E(2r1))] ½ - 1

(1.0345)2 = (1 + 0.0365) (1 + E(2r1))

1.07019025 = 1 + E(2r1))
 1.0365

1.0325 – 1 = E(2r1))

E(2r1)) = 3.25%

6. Suppose we observe the three-year Treasury security rate ( 1R3) to be 12 percent, the
expected one-year rate next year—E (2r1)—to be 8 percent, and the expected one-year rate
the following year— E (3r1)—to be 10 percent. If the unbiased expectations theory of the
term structure of interest rates holds, what is the one-year Treasury security rate?

Answer:

R3 = [(1 + 1R1) (1 + E(2r1)) (1 + E(3r1))]1/3 – 1

1

0.12 = [(1 + 1R1) (1 + 0.08) (1 + 0.10] 1/3 - 1

(1.12)3 = [(1 + 1R1) (1.08) (1.10)] 1/3

1.404928 = (1 + 1R1) + (1.188)

1.188

1.1826 – 1 = (1 + 1R1)

(1 + 1R1) = 18.26%