From discussions with your broker, you have determined that the expected inflation premium is 1.35 percent...

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From discussions with your broker, you have determined that theexpected inflation premium is 1.35 percent next year, 1.50 percentin year 2, 1.75 percent in year 3, and 2.00 percent in year 4 andbeyond. Further, you expect that real risk-free rates will be 3.20percent next year, 3.30 percent in year 2, 3.75 percent in year 3,and 3.80 percent in year 4 and beyond. You are considering aninvestment in either five-year Treasury securities or five-yearbonds issued by PeeWee Corporation. The bonds have no specialcovenants. Your broker has determined the following informationabout economic activity and PeeWee Corporation five-year bonds:
Default risk premium = 2.10%
Liquidity risk premium = 1.75
Maturity risk premium = 0.75
Further, the maturity risk premium on PeeWee bonds is 0.1875percent per year starting in year 2. PeeWee’s default risk premiumand liquidity risk premium do not change with bond maturity.
What is the fair interest rate on five-year Treasurysecurities?
What is the fair interest rate on PeeWee Corporation five-yearbonds?
Plot the five-year yield curve for the Treasurysecurities.
Plot the five-year yield curve for the PeeWee Corporationbonds.

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4.1 Ratings (701 Votes)

a What is thefair interest rate on five year treasurysecuritySol As treasury security is being issued by the governmentthere is no default risk because in finance we believe thatgovernment can not default as they have the ability to print thecurrency and repay the debtLiquidity premium is the overhead See Answer

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From discussions with your broker, you have determined that theexpected inflation premium is 1.35 percent next year, 1.50 percentin year 2, 1.75 percent in year 3, and 2.00 percent in year 4 andbeyond. Further, you expect that real risk-free rates will be 3.20percent next year, 3.30 percent in year 2, 3.75 percent in year 3,and 3.80 percent in year 4 and beyond. You are considering aninvestment in either five-year Treasury securities or five-yearbonds issued by PeeWee Corporation. The bonds have no specialcovenants. Your broker has determined the following informationabout economic activity and PeeWee Corporation five-year bonds:Default risk premium = 2.10%Liquidity risk premium = 1.75Maturity risk premium = 0.75Further, the maturity risk premium on PeeWee bonds is 0.1875percent per year starting in year 2. PeeWee’s default risk premiumand liquidity risk premium do not change with bond maturity.What is the fair interest rate on five-year Treasurysecurities?What is the fair interest rate on PeeWee Corporation five-yearbonds?Plot the five-year yield curve for the Treasurysecurities.Plot the five-year yield curve for the PeeWee Corporationbonds.