ASSIGNMENT 8

Financial Management-I
BBA-II
Instructor: Mehvish Umer
Spring Semester 2021

Question 1: The real risk-free rate of interest, r*, is 3%; and it is expected to remain constant
over time. Inflation is expected to be 2% per year for the next 3 years and 4% per year for the
next 5 years. The maturity risk premium is equal to 0.1(t – 1)%, where t is the number of years to
the bond’s maturity. The default risk premium for a BBB-rated bond is 1.3%.
a) What is the average expected inflation rate over the next 4 years?
b) What is the yield on a 4-year Treasury bond?
c) What is the yield on a 4-year BBB-rated corporate bond with a liquidity premium of
0.5%?
d) What is the yield on an 8-year Treasury bond?
e) What is the yield on an 8-year BBB-rated corporate bond with a liquidity premium of
0.5%?

Question 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 × (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?