Principles of Finance

1. Expected Interest Rate The real risk-free rate is 3%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on a 2-year Treasury securities? What is the yield on 3-year Treasury securities?

2. Default Risk Premium 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 x (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?

Please explain how you got your answer(s):

BOND VALUATION   An investor has two bonds in his portfolio that have a value of $1,000 and a 10% annual coupon. Bond L matures in 15 years, while Bond S matures in 1 year.

a.     What will the value of each bond be if the going interest rate is

– 5%,
– 8%,
– 12%

Assume that only one more interest payment is going to be made on Bond S as its maturity and that 15 more payments are to be made in Bond L.

Please find the values for Bond S and Bond L for each of the above possible interest rates.

b.     Why does the longer-term bond’s price vary more than the shorter-term bond when interest rates change?

BOND RETURNS   Last year Joan purchased a $1,000 face value corporate bond with an 11% annual coupon rate and a 10-year maturity. At the time of the purchase, it had an expected yield to maturity of 9.79%. If Joan sold the bond today for $1,060.49:

1) How much money did she earn in profit, assuming she bought and sold the bond at normal market rates?

2) What rate of return would she have earned on the bond?