# Finance Questions: Risk, Inflation, Interest, Bonds

## Question

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

The real risk-free rate, r*, is 2.5 percent. Inflation is expected to average 2.8 percent a year for the next 4 years, after which time inflation is expected average 3.75 percent a year. Assume that there is no maturity risk premium. An 8-year corporate bond has a yield of 8.3 percent, which includes a liquidity premium of 0.75 percent. What is its default risk premium?

* Heymann Company bonds have 4 years left to maturity. Interest is paid annually, and the bonds have a \$1000 par value and a coupon rate of 9 percent.
a. What is the yield to maturity at a current market price of (1) \$829 or (2) \$1104?
b. Would you pay \$829 for each bond if you thought that a “fair” market interest rate for such bonds was 12 percent – that is, if 4d = 12 percent? Explain your answer

* An 8 percent semiannual coupon bond matures in 5 years. The bond has a face value of \$1000 and a current yield of 8.21 percent. What are the bond’s price and YTM?

## Solution Preview

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

rf = 3% = .03
i1 = .02; i2 = .04; i3 = .04
YTM3 = real rate + inflation3 = .03 + .04 = .07 = 7%....
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