b. Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, AA-rated corporate bond. The current real risk-free rate is 5%, and inflation is expected to be 3% for the next 2 years, 4% for the following 4 years, and 5% thereafter. The maturity risk premium is estimated by this formula: MRP 0.03(1-1)%. The liquidity premium (LP) for the corporate bond is estimated to be 0.2%. You may determine the default risk premium (DRP), given the company's bond rating, from the following table. Remember to subtract the bond's LP from the corporate spread given in the table to arrive at the bond's DRP Corporate Bond Yield US. Treasury Rate 0.83% Spread DRP + LP AAA corporate 0.93 0.10% AA corporate A corporate 133 1.77 0.50 0.94 What yield would you predict for each of these two investments? Round your answers to three decimal places 12-year Treasury yield: 7.553 % 7-year Corporate yield: 7.917 % , Interest Rate Determination and Yield Curves Bb. Finding the yield for each of the two investments 3 Real risk-free rate 5 Expected inflation 5 Expected inflation 5% 3% for the next 2 years 4% for the following 5% 4 years Expected inflation thereafter B Maturity risk premium= Liquidity premium O Maturity of treasury bond 1 Maturity of corporate bond 2 Corporate bond rating 3 412-year Treasury Bond 5 Real risk-free rate. 6 Inflation premium 7 Maturity risk premium 8 12-year Treasury yield 0.03% x(1-1) 0.2% 12 years 7 years AA Formulas #N/A #N/A #N/A #N/A 9 Rating DRP + LP 1 AAA 0.10% 2 AA 0.50% 3 A 0.94% 4 5 7-year Corporate Bond 6 Real risk-free rate 7 Inflation premium #N/A #N/A 8 Maturity risk premium 9 Liquidity premium 0 Default risk premium #N/A #N/A #N/A 17-year corporate yield #N/A 2 33 c. Constructing a graph of the yield curve 34 35 Years to Maturity Yield 36 1 5.27% 37 2 5.32% 38 3 5.48% 39 4 5.53% 40 5 5.47% 41 10 5.57% 42 20 6.17% 43 30 5.79% 44 64d Calculating yields and then constructing a new yield curve graph that shows both the Treasury and the corporate bonds 65 66 Treasury 67 Years yield -Corporate yield Spread 6 1 0.00% 60 2 000% 20 0.00% 71 4 0.00% 72 5 000% 73 10. 0.00% 74 201 0.00% 75 30 0.00%) 76 77 00 81 04 DRP Calculating the rates using geometric averages 97(1) Calculating the 1-year rate, 1 year from now (2) Calculating the 5-year rate, 6 years from now 00 (3) Calculating the 10-year rate, 10 years from now 100 (4) Calculating the 10-year rate, 20 years from now 101 indi Formulas MA MA A A Formulas Treasury -Corporate Years yield yield Spread LP DRP 1 0.00% MA #NIA NA NA 2 0.00% N/A NA NA ANA 3 0.00% NA NA ANA ANA 4 0.00% NA ANA NA MN/A 5 000% A NA A NA 10 000% N/A NA NA NA 20 G00% NA NA A ANA 30 000% NA NA VA NA