1 The real risk free rate (r ) is 2 8 and is expected to remain constant Inflation is expected to be 4 per year for each of the next four years and 3 thereafter The maturity risk premium (MRP) is determined from the formula 0 1(t 1) , where t is the securitys maturity The liquidity premium (LP) on all Gauge Imports Inc s bonds is 1 05 The following table shows the current relationship between bond ratings and default risk premiums (DRP) Rating Default Risk Premium U S Treasury AAA 0 60 AA 0 80 A 1 05 BBB 1 45 a) Gauge Imports Inc issues 14 year, AA rated bonds What is the yield on one of these bonds Disregard cross product terms that is, if averaging is required, use the arithmetic average A 5 95 B 7 94 C 9 24 D 8 19 Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true A Higher inflation expectations increase the nominal interest rate demanded by investors B A BBB rated bond has a lower default risk premium as compared to an AAA rated bond 2 a) The yield on a one year Treasury security is 4 4600 , and the two year Treasury security has a 6 6900 yield Assuming that the pure expectations theory is correct, what is the markets estimate of the one year Treasury rate one year from now (Note Do not round your intermediate calculations ) 10 2231 7 6225 11 3889 8 9676 b) Recall that on a one year Treasury security the yield is 4 4600 and 6 6900 on a two year Treasury security Suppose the one year security does not have a maturity risk premium, but the two year security does and it is 0 25 What is the markets estimate of the one year Treasury rate one year from now (Note Do not round your intermediate calculations ) 8 4575 10 741 7 1889 9 6415 c) Suppose the yield on a two year Treasury security is 5 83 , and the yield on a five year Treasury security is 6 20 Assuming that the pure expectations theory is correct, what is the markets estimate of the three year Treasury rate two years from now (Note Do not round your intermediate calculations ) 7 10 6 53 6 61 6 45 I DO NOT NEED EXPLANATIONS ANSWERS ONLY

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#1 The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next four years and 3% thereafter.

The maturity risk premium (MRP) is determined from the formula: 0.1(t 1)%, where t is the securitys maturity. The liquidity premium (LP) on all Gauge Imports Inc.s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

Rating	Default Risk Premium
U.S. Treasury
AAA	0.60%
AA	0.80%
A	1.05%
BBB	1.45%

a) Gauge Imports Inc. issues 14-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average.

A. 5.95%

B. 7.94%

C. 9.24%

D. 8.19%

Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?

A. Higher inflation expectations increase the nominal interest rate demanded by investors.

B. A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.

a) The yield on a one-year Treasury security is 4.4600%, and the two-year Treasury security has a 6.6900% yield. Assuming that the pure expectations theory is correct, what is the markets estimate of the one-year Treasury rate one year from now? (Note: Do not round your intermediate calculations.)

10.2231%

7.6225%

11.3889%

8.9676%

b) Recall that on a one-year Treasury security the yield is 4.4600% and 6.6900% on a two-year Treasury security. Suppose the one-year security does not have a maturity risk premium, but the two-year security does and it is 0.25%. What is the markets estimate of the one-year Treasury rate one year from now? (Note: Do not round your intermediate calculations.)

8.4575%

10.741%

7.1889%

9.6415%

c) Suppose the yield on a two-year Treasury security is 5.83%, and the yield on a five-year Treasury security is 6.20%. Assuming that the pure expectations theory is correct, what is the markets estimate of the three-year Treasury rate two years from now? (Note: Do not round your intermediate calculations.)

7.10%

6.53%

6.61%

6.45%

I DO NOT NEED EXPLANATIONS< ANSWERS ONLY