Lahore School of Economics

Financial Management I
Chapter 6
Assignment 6 Solution
Class Examples

Q1) r = r* + IP + MRP + LP + DRP

r = 2% + 3% + 2% + 1% + 1%
r = 9%

Q2) T-bill rate = r* + IP

5.5% = r* + 3.25%
r* = 2.25%.

Q3) r = r* + IP + DRP + LP + MRP.

Since these are Treasury securities, DRP = LP = 0.

rT2 = r* + IP2.
IP2 = (2% + 4%)/2 = 3%.
rT2 = 3% + 3% = 6%.

rT3 = r* + IP3.
IP3 = (2% + 4% + 4%)/3 = 3.33%.
rT3 = 3% + 3.33% = 6.33%.

Q4)
a) Average inflation over 4 years = (2% +2% + 2% + 4%) / 4 = 2.5%

b) T4 = rRF + MRP4
= r* + IP4 + MRP4
= 3 + 2.5 + (0.1)*3
= 5.8%

c) C4, BBB = r* + IP4 + MRP4 + DRP + LP

= 3 + 2.5 + (0.1)*3 + 1.3 + 0.5
= 7.6%

d) T8 = r* + IP4 + MRP4
= 3 + 3.25 + (0.1)*7
= 6.95%

IP8 = (2 + 2 + 2 + 4 + 4 + 4 + 4 + 4) / 8 = 3.25%

e) C8, BBB = r* + IP8 + MRP8 + DRP + LP

= 3 + 6.95 + (0.1)*7 + 1.3 + 0.5
= 8.75%

f) T9 = r* + IP9 + MRP9
7.3 = 3 + IP9 + (0.1)*8
IP9 = 3.5%

IP9 = (2 + 2 + 2 + 4 + 4 + 4 + 4 + 4 + Inflation Year 9) / 9

3.5 = (26 + Inflation Year 9) / 9
31.5 = 26 + Inflation Year 9
Inflation Year 9 = 5.5%

Q5) MRP = 0.1%(5 – 1) = 0.4%.

r = r* + IP + MRP + LP + DRP
7.75% = 2.3% + 2.5% + 0.4% + 1.0% + DRP
DRP = 1.55%

Q6) a) Yield of 1-year security, 1 year from now:

 1.062  2   1.06   1  X 
 1.062 
2

 1 X  
 1.06 
1  X  1.064
X  6.4%

b) Yield of 1-year security, 2 years from now:

 1.063   1.062  1 X 

3 2

 1.063
3

 1 X  
 1.062 
2

1  X  1.065
X  6.5%

c) Yield of 2-year security, 1 year from now:

 1.063   1.06   1  X 
3 2

 1.063 3
 1 X 
2

 1.06 
 1  X   1.13317
2

 1  X    1.13317  1/ 2
X  6.45%

Q7) Let X equal the yield on 2-year securities 4 years from now:
(1.07)4(1 + X)2 = (1.075)6
(1.3108)(1 + X)2 = 1.5433
1/2
1.5433
1+X =
( 1.3108 )
X = 8.5%.

Problems for Assignment

Q1) rT10 = 6%; rC10 = 8%; LP = 0.5%; DRP = ?

r = r* + IP + DRP + LP + MRP.
rT10 = 6% = r* + IP10 + MRP10; DRP = LP = 0.

rC10 = 8% = r* + IP10 + DRP + 0.5% + MRP10.

Because both bonds are 10-year bonds the inflation premium and maturity risk premium on both bonds are
equal. The only difference between them is the liquidity and default risk premiums.
 rC10 = 8% = r* + IP10 + MRP10 + 0.5% + DRP. But we know from above that r* + IP10 + MRP10 = 6%

rC10 = 8% = 6% + 0.5% + DRP

1.5% = DRP.

Q2) rT2 = r* + IP2 + MRP2 = 6.2%

rT2 = 3% + 3% + MRP2 = 6.2%
MRP2 = 0.2%.

Q3) (1 + rT2)2 = (1.05)(1.06)

(1 + rT2)2 = 1.113
1 + rT2 = 1.055
rT2 = 5.5%.

Q4) r7 = r* + IP7 + MRP7 + DRP + LP.

r* = 0.03.
IP7 = [0.03 + 0.04 + (5)(0.035)]/7 = 0.035.
MRP7 = 0.0005(t – 1) = 0.0005(6) = 0.003.
DRP = 0. LP = 0.

rT7 = 0.03 + 0.035 + 0.003 = 0.068 = 6.8%.

Q5) rC8 = r* + IP8 + MRP8 + DRP8 + LP8

8.3% = 2.5% + (2.8%  4 + 3.75%  4)/8 + 0.0% + DRP8 + 0.75%
8.3% = 2.5% + 3.275% + 0.0% + DRP8 + 0.75%
8.3% = 6.525% + DRP8
DRP8 = 1.775%.

Q6) Let X equal the yield on a 1-year bond 1 year from now:
(1.07)(1 + X) = (1.09)2
(1.07)(1 + X) = 1.1881
 1.1881 
 
1 + X =  1.07 
X = 11.04%

Q7) (1.045)2 = (1.03)(1 + X)

1.092/1.03 = 1 + X
X = 6%.