Chapter 6 Problem Solutions
63
r* = 3%; I
1
= 2%; I
2
= 4%; I
3
= 4%; MRP = 0; r
T2
= ?; r
T3
= ?
r = r* + IP + DRP + LP + MRP.
Since these are Treasury securities, DRP = LP = 0.
r
T2
= r* + IP
2
.
IP
2
= (2% + 4%)/2 = 3%.
r
T2
= 3% + 3% = 6%.
r
T3
= r* + IP
3
.
IP
3
= (2% + 4% + 4%)/3 = 3.33%.
r
T3
= 3% + 3.33% = 6.33%.
612
First, calculate the inflation premiums for the next three and five years,
respectively.
They are IP
3
= (2.5% + 3.2% + 3.6%)/3 = 3.1% and IP
5
= (2.5% +
3.2% + 3.6% + 3.6% + 3.6%)/5 = 3.3%.
The real riskfree rate is given as 2.75%.
Since the default and liquidity premiums are zero on Treasury bonds, we can now
solve for the maturity risk premium.
Thus, 6.25% = 2.75% + 3.1% + MRP
3
, or
MRP
3
= 0.4%.
Similarly, 6.8% = 2.75% + 3.3% + MRP
5
, or MRP
5
= 0.75%.
Thus, MRP
5
– MRP
3
= 0.75% – 0.40% = 0.35%.
618
a.
Years to
Real RiskFree
Maturity
Rate (r*)
IP**
MRP
r
T
= r* + IP + MRP
1
2%
7.00%
0.2%
9.20%
2
2
6.00
0.4
8.40
3
2
5.00
0.6
7.60
4
2
4.50
0.8
7.30
5
2
4.20
1.0
7.20
10
2
3.60
1.0
6.60
20
2
3.30
1.0
6.30
**The computation of the inflation premium is as follows:
Expected
Average
Year
Inflation
Expected Inflation
1
7%
7.00%
2
5
6.00
3
3
5.00
4
3
4.50
5
3
4.20
10
3
3.60
20
3
3.30
For example, the calculation for 3 years is as follows:
3
%
3
%
5
%
7
+
+
= 5.00%.
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Thus, the yield curve would be as follows:
b.
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 Spring '08
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 Finance, Interest, Interest Rate, Percentage point, default risk premium

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