Running Head: FINANCIAL MARKETS AND INTEREST RATES & THE MEANING AND

MEASUREMENT OF RISK AND RETURN1

Financial Markets and Interest Rates & The Meaning and

Measurement of Risk and Return

Student’s Name

Institution Affiliation
 FINANCIAL MARKETS AND INTERSET RATES AND THE MEANING AND
MEASUREMENT OF RISK AND RETURN. 2

Part 1

1. The current 3-month Treasury bill rate is 2.86 percent, the 30-year Treasury bond rate is

5.83 percent, the 30-year Aaa-rated corporate bond rate is 7.21 percent, and the inflation

rate is 2.10 percent.

2. The risk-free rate of interest is the difference between the average yield on 3- month

Treasury bills and the inflation rate.

Treasury Bill = 2.86 %

Inflation rate = 2.10 %

Therefore, interest risk-free rate = (2.86% - 2.10%) = 0.76%

3. The default-risk premium is estimated by the difference between the average yields on

Aaa-rated bonds and 30-year Treasury bills.

Average yield on Aaa-rated corporate bond = 7.21%

30-year Treasury bills = 5.83 %

Therefore, the default risk-premium = 1.38%

4. The maturity-risk premium is estimated by the difference between the average yields on

30-year Treasury bonds and 3 month Treasury bills.

30-year Treasury bills = 5.83 %

Treasury Bill = 2.86 %

Therefore, Maturity risk-premium = 2.97%

 FINANCIAL MARKETS AND INTERSET RATES AND THE MEANING AND
MEASUREMENT OF RISK AND RETURN. 3

Part II

Explain in your own words what the difference between the concepts of the inflation

premium and the default-risk premium and between the concepts of the maturity-risk

premium and the liquidity-risk premium.

i) The main difference is that, the inflation risk-premium is a component of the nominal interest

that compensates a capitalist for the loss of value of his investment due to factors such as

inflation during the period of the investment. While on the other hand, default risk-premium can

be referred to as the difference between a debt interest rate and the risk-free rate. It exists to

compensate capitalist for an unanticipated likelihood of defaulting on their debts.

ii) The maturity risk-premium refers to the amount of extra return available on a capitalist

investment through buying a bond that has a longer maturity date. These risks are designed to

compensate capitalists for taking the risk of holding longer maturity bonds. While on the other

hand, we can refer to the liquidity risk premium as an additional return on bonds which are not

actively traded. This is because they are not easily purchased or sold at fair market prices.

2. Examine the securities below and identify and explain in your own words the

Security with the highest liquidity premium, the highest default risk premium, and the

highest maturity premium.

a. 30-year U.S. Government Treasury bond maturing in 2025

Highest liquidity premium is equal to, 5.49 % × 5.83 % = 32.0067%

c. 10-year Aaa-rated corporate bond maturing in 2020, thinly traded on a regional

 FINANCIAL MARKETS AND INTERSET RATES AND THE MEANING AND
MEASUREMENT OF RISK AND RETURN. 4

exchange

Highest default risk premium is 6.35 % × 1.38 % = 8.763 %

d. 3-month U.S. Treasury bill

Highest maturity premium is 3.04 % × 2.97 % = 9.0288 %

3. The yield curve in 2009 was very low, with short-term rates close to zero and long-term

rates below 5 percent. In your own words, what factors contributed to such low interest

rates?

There are two main factors that that may have contributed to such low interest rates.

Foremost, the rise of bond prices can be a factor. For instance, when interest rates are low – say

0.5 percent, this makes bond prices attractive to other capitalists hence their prices will increase.

Second, is the decrease of inflation rate thereby heightening the bond prices. The reason for this

is because a rise in inflation limits the purchasing power of what an investor will earn on his

investment.

Part III

4. You are given the following probability distribution for XYZ common stock's

returns during the next year, which are assumed to be normally distributed. Show all

work, and complete the following:

Return Probability

12% 20%
 FINANCIAL MARKETS AND INTERSET RATES AND THE MEANING AND
MEASUREMENT OF RISK AND RETURN. 5

16% 60%

20% 20%

a. Calculate the standard deviation of the returns, and round to the nearest one-half

percent.

Solution

The first step is to find the mean return as calculated below :

12% + 16% + 20% = 48%

48 % ÷ 3 = 16%

The second step is to calculate the difference between each observed return and the calculated

mean return

(0.12 - 0.16)^2 × 0.2 = 0.032

(0.16 – 0.16)^2 × 0.6 = 0

(0.20 – 0.16)^2 × 0.2 = 0.032

Total = 0.064

The third step is to get the variance

0.064/ (3-1) = 0.032

Lastly, we get the standard deviation as follows

 FINANCIAL MARKETS AND INTERSET RATES AND THE MEANING AND
MEASUREMENT OF RISK AND RETURN. 6

√0.032 = 0.1789