Assume that the Liquidity Preference Theory of the term structure is correct and that you expect...
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Assume that the Liquidity Preference Theory of the term structure is correct and that you expect the annual real rate of return to be constant over at least the next 10 years at 1.50 percent, that you expect average annual inflation to be 1.0 percent each year for the next 2 years (Years 1-2), but then, because of government spending and the effect of the federal stimulus package and health care, to jump to 6.0 percent for years 3-7, but to then settle down to a lower, constant rate in all later years. Also assume that the maturity risk premium can be defined as (0.20%) *(t-1) and that the yield on a 10-year corporate security is 9.80 percent, which includes a liquidity premium of 0.65 percent and a default risk premium of 1.75 percent. Given this information, determine the average annual return on a 5-year corporate security to be bought at the end of Year 3 (beginning of Year 4) and held over Years 4, 5, 6, 7 and 8, if the liquidity premium on this security will be 0.10 percent and the default premium will be 0.45 percent. Assume that the Liquidity Preference Theory of the term structure is correct and that you expect the annual real rate of return to be constant over at least the next 10 years at 1.50 percent, that you expect average annual inflation to be 1.0 percent each year for the next 2 years (Years 1-2), but then, because of government spending and the effect of the federal stimulus package and health care, to jump to 6.0 percent for years 3-7, but to then settle down to a lower, constant rate in all later years. Also assume that the maturity risk premium can be defined as (0.20%) *(t-1) and that the yield on a 10-year corporate security is 9.80 percent, which includes a liquidity premium of 0.65 percent and a default risk premium of 1.75 percent. Given this information, determine the average annual return on a 5-year corporate security to be bought at the end of Year 3 (beginning of Year 4) and held over Years 4, 5, 6, 7 and 8, if the liquidity premium on this security will be 0.10 percent and the default premium will be 0.45 percent.
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Answer rating: 100% (QA)
To solve this problem we will use the liquidity preference theory of the term structure which suggests that longterm interest rates are determined by ... View the full answer
Related Book For
Fundamentals of Investments
ISBN: 978-0132926171
3rd edition
Authors: Gordon J. Alexander, William F. Sharpe, Jeffery V. Bailey
Posted Date:
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