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# Tut02q - July 2009 Strictly for course AB102(2009 internal...

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July 2009 Strictly for course AB102 (2009) internal circulation only. Nanyang Business School AB102 Financial Management Tutorial 2: Financial Markets and Institutions, Interest Rates (Common Questions) 1) (6-14) Expectations theory and inflation . Suppose 2-year Treasury bonds yield 4.5 percent, while 1-year bonds yield 3 percent. r* is 1 percent, and the maturity risk premium is zero. a) Using the expectations theory, what is the yield on a 1-year bond, 1 year from now? b) What is the expected inflation rate in Year 1? Year 2? 2) (6-11) Default risk premium . A company’s 5-year bonds are yielding 7.75 percent per year. Treasury bonds with the same maturity are yielding 5.2 percent per year, and the real risk-free rate ( r* ) is 2.3 percent. The average inflation premium is 2.5 percent, 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 percent, what is the default risk premium on the corporate bonds? 3) (6-17) Interest rate premium . A 5-year Treasury bond has a 5.2 percent yield. A 10- year Treasury bond yields 6.4 percent, and a 10-year corporate bond yields 8.4 percent. The market expects that inflation will average 2.5 percent over the next 10 years (IP 10 = 2.5%). Assume that there is no maturity risk premium (MRP = 0), and that the annual real risk-free

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Tut02q - July 2009 Strictly for course AB102(2009 internal...

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