   Chapter 6, Problem 17P Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

Solutions

Chapter
Section Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

INTEREST RATE PREMIUMS A 5-year Treasury bond has a 5.2% yield. A 10-year Treasury bond yields 6.4%, and a 10-year corporate bond yields 8.4%. The market expects that inflation will average 2.5% over the next 10 years (IP10 = 2.5%). Assume that there is no maturity risk premium (MRP = 0) and that the annual real risk-free rate, r″, will remain constant over the next 10 years. (Hint: Remember that the default risk premium and the liquidity premium are zero for Treasury securities: DRP = LP = 0.) A 5-year corporate bond has the same default risk premium and liquidity premium as the 10-year corporate bond described. What is the yield on this 5-year corporate bond?

Summary Introduction

To identify: The expected yield on 5-year Treasury bond.

Introduction:

Yield:

The yield is the percentage of the securities at which the return is provided by the company to its investors. Yield can be used in the form of dividend and interest.

Explanation

In order to compute the yield on 5-year Treasury bond; the real risk-free rate of10-year Treasury bond, the inflation premium on 5-year Treasury bond, and the total value of liquidity premium and default risk premium on 10-year bond need to calculate.

Compute the real risk-free rate

Given,

The yield of 10-year Treasury bond is 6.4%.

The inflation rate at 10-year is 2.5%.

Formula to calculate the real risk-free rate derives from the formula of expected yield,

rT10=r*+IP10r*=rT10IP10

Where,

• r* is the real-risk free rate.
• rT10 is yield of treasury bonds.
• IP10 is inflation premium.

Substitute 6.4% for rT10 and 2.5% for IP.

r*=6.4%2.5%=3.9% (1)

The real risk-free rate is 3.9%.

Compute the inflation premium on 5-year Treasury bond

The yield at 5-year Treasury securities is 5.2%. (Given)

The real risk-free rate is 3.9%. (Calculated in equation (1))

Formula to calculate the inflation premium derives from the formula of expectedyield,

rT5=r*+IP5IP5=rT5r*

Where,

• r* is real-risk free rate.
• rT5 is yield of treasury bonds.
• IP5 is inflation premium.

Substitute 5.2% for rT5 and 3.9% for r*.

IP5=5.2%3.9%=1.3% (2)

The inflation premium of 5 year is 1.3%.

Compute the liquidity premium and default risk premium

The yield of 10-year corporate bond is 8.4%. (Given)

The real risk-free rate is3.9%. (Calculated in equation (1))

The inflation premium of 10 year is 2.5%. (Given)

Formula to calculate the default risk premium, liquidity premium derives from the formula of yield,

rC10=r*+IP10+DRP10+LP10DRP10+LP10=rC10(r*+IP10)

Where,

• DRP10 is the default risk premium

Still sussing out bartleby?

Check out a sample textbook solution.

See a sample solution

The Solution to Your Study Problems

Bartleby provides explanations to thousands of textbook problems written by our experts, many with advanced degrees!

Get Started

MULTIPLE IRRS AND MIRR A mining company is deciding whether to open a strip mine, which costs 2 million. Cash i...

Fundamentals of Financial Management, Concise Edition (with Thomson ONE - Business School Edition, 1 term (6 months) Printed Access Card) (MindTap Course List)

Why might purchasing power parity fail to hold?

Fundamentals of Financial Management (MindTap Course List)

Managerial Accounting: The Cornerstone of Business Decision-Making

Calculate the missing items in the following:

College Accounting (Book Only): A Career Approach

What number of days is considered as a year by most banks and businesses in computing interest?

College Accounting, Chapters 1-27 (New in Accounting from Heintz and Parry)

What distinguishes money from other assets in the economy?

Principles of Macroeconomics (MindTap Course List) 