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Unformatted text preview: 41k* = 3%; I1= 2%; I2= 4%; I3= 4%; MRP = 0; kT2= ?; kT3= ?k = k* + IP + DRP + LP + MRP.Since these are Treasury securities, DRP = LP = 0.kT2= k* + IP2.IP2= (2% + 4%)/2 = 3%.kT2= 3% + 3% = 6%.kT3= k* + IP3.IP3= (2% + 4% + 4%)/3 = 3.33%.kT3= 3% + 3.33% = 6.33%.42kT10= 6%; kC10= 8%; LP = 0.5%; DRP = ?k = k* + IP + DRP + LP + MRP.kT10= 6% = k* + IP + MRP; DRP = LP = 0.kC10= 8% = k* + IP + DRP + 0.5% + MRP.Because both bonds are 10year bonds the inflation premium and maturity risk premium on both bonds are equal. The only difference between them is the liquidity and default risk premiums.kC10= 8% = k* + IP + MRP + 0.5% + DRP. But we know from above that k* + IP + MRP = 6%; therefore,kC10= 8% = 6% + 0.5% + DRP1.5% = DRP.43kT1= 5%; 1kT1= 6%; kT2= ?kT2= = 5.5%.44k* = 3%; IP = 3%; kT2= 6.2%; MRP2= ?kT2= k* + IP + MRP = 6.2%kT2= 3% + 3% + MRP = 6.2%MRP = 0.2%.4  1SOLUTIONS TO ENDOFCHAPTER PROBLEMS45Let x equal the yield on 2year securities 4 years from now:7.5% = [(4)(7%) + 2x]/60.45 = 0.28 + 2xx = 0.085 or 8.5%.46k = k* + IP + MRP + DRP + LP.k* = 0.03.IP = [0.03 + 0.04 + (5)(0.035)]/7 = 0.035.MRP = 0.0005(6) = 0.003.DRP = 0.LP = 0.kT7= 0.03 + 0.035 + 0.003 = 0.068 = 6.8%.47a. k1= 3%, andk2= = 4.5%,Solving for k1in Year 2, 1k1, we obtain1k1= (4.5% 2)  3% = 6%.b. For riskless bonds under the expectations theory, the interest rate for a bond of any maturity is kn= k* + average inflation over n years. If k* = 1%, we can solve for IPn:Year 1: k1= 1% + I1= 3%;I1= expected inflation = 3%  1% = 2%.Year 2: k1= 1% + I2= 6%;I2= expected inflation = 6%  1% = 5%.Note also that the average inflation rate is (2% + 5%)/2 = 3.5%, which, when added to k* = 1%, produces the yield on a 2year bond, 4.5 percent. Therefore, all of our results are consistent....
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 Spring '10
 ANTHONYCRINITI

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