Assign.

Structure of Interest Rates

PROBLEMS 1. Find the nominal interest rate for a debt security given the following information: real rate = 2%, liquidity premium = 2%, default risk premium = 4%, maturity risk premium = 3%, and the inflation premium = 3%. 2. Find the default risk premium for a debt security given the following information: inflation premium = 3%, maturity risk premium = 2.5%, real rate = 3%, liquidity premium = 0%, and the nominal interest rate is 10%. 3. Assume that the interest rate on a one-year Treasury bill is 6 percent and the rate on a twoyear Treasury note is 7 percent. r = RR + IP IP = r RR a. If the expected real rate of interest is 3 percent, determine the inflation premium on the Treasury bill. b. If the maturity risk premium is expected to be zero, determine the inflation premium on the Treasury note. c. What is the expected inflation premium for the second year? 4. A Treasury note with a maturity of four years carries a nominal rate of interest of 10 percent. In contrast, an 8-year Treasury bond has a yield of 8 percent. r = RR + IP RR = r IP a. If inflation is expected to average 7 percent over the first four years, what is the expected real rate of interest? b. If the inflation rate is expected to be 5 percent for the first year, calculate the average annual rate of inflation for years two through four. c. If the maturity risk premium is expected to be zero between the two Treasury securities, what will be the average annual inflation rate expected over years five through eight? 5. The interest rate on a ten-year Treasury bond is 9.25 percent. A comparable maturity Aaarated corporate bond is yielding 10 percent. Another comparable maturity but lower quality corporate bond has a yield of 14 percent which includes a liquidity premium of 1.5 percent. r = RR + IP + DRP + MRP + LP Treasury bond rate (TBR) = RR + IP DRP = r TBR MRP LP a. Determine the default risk premium on the Aaa-rated bond. b. Determine the default risk premium on the lower quality corporate bond. 6. A corporate bond has a nominal interest rate of 12 percent. This bond is not very liquid and consequently requires a 2 percent liquidity premium. The bond is of low quality and thus

Assign.Structure of Interest Rates

has a default risk premium of 2.5 percent. The bond has a remaining life of 25 years resulting in a maturity risk premium of 1.5 percent. Treasury bond rate (TBR) = RR + IP r = TBR + DRP + MRP + LP a. Estimate the nominal interest rate on a Treasury bond. b. What would be the inflation premium on the Treasury bond if investors required a real rate of interest of 2.5 percent?