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The interest rate on debt, r, 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 real risk-free rate of interest may be thought of as the interest rate on U.S. Treasury securities in an inflation-free world. A Treasury Infla inn Protected Security (TIPS) is free of most risks, and its value increases with inflation. Short-term TIPS are free of defauit, matunty, and fiquidity 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 risk of default, the higher the market rate. The average default risk premium varies over time, and it tends to get 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 liquid than financial assets, but different financil assets vary in their liquidity, Assets with higher trading volume are generally liquid. The average liquidity premitam yaries over time. Although investing in short-term T-bilis preserves one's on long-term borids. Quantitative Problem: An analyst evaluating securities has obtained the following information. The real rate of interest is 2.7% and is expected to remain constant for the next 5 yean. Inflation is expected to be 2.1% next year, 3.1% the following yeas, 4.1% the third year, and .5.1% every year therealtec. The maturity nisk prenilurn is estimated to risk of default, the higher the market rate. The average default risk. pren A liquid asset can be converted to cosh quickly at a "fair market value." Real assets are generally liquid than finercial assets, but different firsancial ascess vary in their liquidity. Assets with higher trading volume are generally liquid. The average liquidty premium varies over time. on long-term bonds. Quantitative Problemt An analyst evaluoting securities has obtained the following information. The real rete of interest is 2.7% and is expected to remain conutant for ine nest 5 vees. be 0.1(t1)%, where t= number of years to maturity. The liquidity premium en celevant 5 -year secunties is 0.5% and the default rodk premium on relievane 5 ? year securities is 1% : a. What is the yield on a 1-yeor T-biliz Round your answer to one decimal place. b. What is the yield on a 5 -year T-bond? Round your answer to one ifecimal place. c. What is the virid on a 5 -year corporate bond? Alound your answer to one decimal place