Ch 04: Blueprint Problems - Bonds Valuation The Interest rate on debt, ra, is equal to the real risk-free rate plus an inflation premium plus a default risk premium plus a liquidity premium plus a maturity risk premium. The interest rate on debt, ra, is also equal to the [-Select-risk-free rate plus a default risk premium plus a liquidity premium plus a maturity risk premium. The real risk-free rate of interest may be thought of as the interest rate on [-Select- U.S. Treasury securities in an inflation-free world. A Treasury Inflation-Protected Security (TIPS) is free of most risks, and its value increases with inflation. Short-term TIPS are free of default, maturity, and liquidity risks and of risk due to changes in the general level of interest rates. However, they are not free of changes in the real rate. Our definition of the risk-free rate assumes that, despite the recent downgrade, Treasury securities have no meaningful default risk. The inflation premium is equal to the average expected inflation rate over the life of the security. Default means that a borrower will not make scheduled interest or principal payments, and it affects the market interest rate on a bond. The -Select-the bond's risk of default, the higher the market rate. The average default risk premium varies over time, and it tends to get [-Select- when the economy is weaker and borrowers are more likely to have a hard time paying off their debts. A liquid asset can be converted to cash quickly at a "fair market value." Real assets are generally -Select- liquid than financial assets, but different financial assets vary in their liquidity. Ass trading volume are generally -Select- liquid. The average liquidity premium varies over time. The prices of long-term bonds -Select- -Select- whenever interest rates rise. Because interest rates can and do occasionally rise, all long-term bonds, even Treasury bonds, have an element of risk called -Select- rate risk. Therefore, a(n) -Select-risk premium, which is higher the longer the term of the bond, is included in the required interest rate. While long-term bonds are heavily exposed to rate risk, short-term bills are heavily exposed to -Select- risk. Although investing in short-term T-bills preserves one's -Select-, the interest income provided by short-term T-bills is -Select-stable than the interest income on long-term bonds. Quantitative Problem: An analyst evaluating securities has obtained the following information. The real rate of interest is 2.9% and is expected to remain constant for the next 5 years. Inflation is expected to be 2.6% next year, 3.6% the following year, 4.6% the third year, and 5.6% every year thereafter. The maturity risk premium is estimated to be 0.1 x (t-1) %, where t = number of years to maturity. The liquidity premium on relevant 5-year securities is 0.5% and the default risk premium on relevant 5-year securities is 1%. a. What is the yield on a 1-year T-bill? Do not round intermediate calculations. Round your answer to one decimal place. % b. What is the yield on a 5-year T-bond? Do not round intermediate calculations. Round your answer to one decimal place. % with higher c. What is the yield on a 5-year corporate bond? Do not round intermediate calculations. Round your answer to one decimal place. %

detr, rin is alvo equal to the risk-tree rate plus a defoult nak premlum plus a louldity premium plus a maturity fik premium. The res risk-free rate of interest may be thoupht of as the inkerest rate ea The inflation premium is equal to the average expected infation rate over the life of the securtiy: Detault means that a borrower will not make scheduled interest or principal payments, and z affects the markat interest rate en a bond. The the bends risk of defaut, the hipher the market rateThe average defaut risk premium varies over time, ahd it tends so get when the economy is webler and borrowers are more lkely to hove a hard time parying of their debts. A liquid asset can be converted to cash quichly at a "fair market value." Real assets are generally hiqua than financial assets, but cifferenk financial assets vary in their logidity Assets wah Nigher trading volume are penerally lovid, The everase liguidty permium varies over bme. The pricts of loep-term bonds whenever knterest rates rise. Because interest rates can and do occasionally rise, al long-term bonds, even Treasury bonds, have an element of risk ealled rate nik. Therefore, a(o) risk premium, which is higher the preger the term of the bond, is included in the required interest rate. While long-term bends are hemily erposed to rate rik, short-term bilis are heavlly exposed to riak. Although imvesting is shertuterm Tublis preserves one's the interest income provided by thert-term T-bals is stable than the interevt income on long-term boods. Quantitative Problem: relevant 5 -year secunties is 0.5% and the default riak premium on relevant 5 - vear securcies is 1%. a. What is the yield on a 1 pear fabin Da not round intermed ate calculabions. Round your answer to ene dedimal place. b. What is the yield on a S-year T-bond Do not round intemed ate calculatione. Round your anseref to ane decinal plack. c. What is the yieid on a s.year corporate bond? De not round intermediate calculations Round your answer to one decimal place. detr, rin is alvo equal to the risk-tree rate plus a defoult nak premlum plus a louldity premium plus a maturity fik premium. The res risk-free rate of interest may be thoupht of as the inkerest rate ea The inflation premium is equal to the average expected infation rate over the life of the securtiy: Detault means that a borrower will not make scheduled interest or principal payments, and z affects the markat interest rate en a bond. The the bends risk of defaut, the hipher the market rateThe average defaut risk premium varies over time, ahd it tends so get when the economy is webler and borrowers are more lkely to hove a hard time parying of their debts. A liquid asset can be converted to cash quichly at a "fair market value." Real assets are generally hiqua than financial assets, but cifferenk financial assets vary in their logidity Assets wah Nigher trading volume are penerally lovid, The everase liguidty permium varies over bme. The pricts of loep-term bonds whenever knterest rates rise. Because interest rates can and do occasionally rise, al long-term bonds, even Treasury bonds, have an element of risk ealled rate nik. Therefore, a(o) risk premium, which is higher the preger the term of the bond, is included in the required interest rate. While long-term bends are hemily erposed to rate rik, short-term bilis are heavlly exposed to riak. Although imvesting is shertuterm Tublis preserves one's the interest income provided by thert-term T-bals is stable than the interevt income on long-term boods. Quantitative Problem: relevant 5 -year secunties is 0.5% and the default riak premium on relevant 5 - vear securcies is 1%. a. What is the yield on a 1 pear fabin Da not round intermed ate calculabions. Round your answer to ene dedimal place. b. What is the yield on a S-year T-bond Do not round intemed ate calculatione. Round your anseref to ane decinal plack. c. What is the yieid on a s.year corporate bond? De not round intermediate calculations Round your answer to one decimal place