Assignment 03

Introduction to Finance
Cost of Money
Q.1 Due to a recession, expected inflation this year is only 3%. However, the inflation rate in
Year 2 and thereafter is expected to be constant at some level above 3%. Assume that the
expectations theory holds and the real risk-free rate (r*) is 2%. If the yield on 3-year Treasury
bonds equals the 1-year yield plus 2%, what inflation rate is expected after Year 1?
Q.2 A company’s 5-year bonds are yielding 7.75% per year.Treasury bonds with the same
maturity are yielding 5.2% per year, and the real risk-free rate (r*) is 2.3%. The average inflation
premium is 2.5%; and the maturity risk premium is estimated to be 0.1 x (t — 1)%, where t =
number of years to maturity. If the liquidity premium is 1%, what is the default risk premium on
the corporate bonds?
Q. 3 An investor in Treasury securities expects inflation to be 2.5% in Year 1, 3.2% in Year 2,
and 3.6% each year thereafter. Assume that the real risk-free rate is 2.75% and that this rate will
remain constant. Three-year Treasury securities yield 6.25%, while 5-year Treasury securities
yield 6.80%. What is the difference in the maturity risk premiums (MRPs) on the two securities;
that is, what is MRP5 — MRP3?
Q. 4 The real risk-free rate, r*, is 2.5%. Inflation is expected to average 2.8% a year for the next
4 years, after which time inflation is expected to average 3.75% a year. Assume that there is no
maturity risk premium. An 8-year corporate bond has a yield of 8.3%, which includes a liquidity
premium of 0.75%. What is its default risk premium?

Deadline: Wednesday, 06 April, 2022