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 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0.03(t-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 Rate Spread = DRP + LP U.S. Treasury 0.83% AAA corporate 1.03 0.20% AA corporate 1.35 0.52 A corporate 1.69 0.86 What yield would you predict for each of these two investments? Round your answers to three decimal places. % 12-year Treasury yield: % 7-year Corporate yield: c. Given the following Treasury bond yield information, construct a graph of the yield curve. Maturity Yield 1 year 5.42% 2 years 5.47 3 years 5.66 4 years 5.72 5 years 5.65 10 years 5.77 20 years 6.35 30 years 5.98 d. Based on the information about the corporate bond provided in part b, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds. Round your answers to two decimal places. Years Treasury yield AA-corporate yield 1 5.42% 2 5.47% 3 5.66% 4 5.72% 5 5.65% 10 5.77% 20 6.35% 30 5.98% % % % % % % % % f. Using the Treasury yield information in part c, calculate the following rates using geometric averages (round your answers to three decimal places): 1. The 1-year rate, 1 year from now % 2. The 5-year rate, 5 years from now % 3. The 10-year rate, 10 years from now % 4. The 10-year rate, 20 years from now % 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 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0.03(t-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 Rate Spread = DRP + LP U.S. Treasury 0.83% AAA corporate 1.03 0.20% AA corporate 1.35 0.52 A corporate 1.69 0.86 What yield would you predict for each of these two investments? Round your answers to three decimal places. % 12-year Treasury yield: % 7-year Corporate yield: c. Given the following Treasury bond yield information, construct a graph of the yield curve. Maturity Yield 1 year 5.42% 2 years 5.47 3 years 5.66 4 years 5.72 5 years 5.65 10 years 5.77 20 years 6.35 30 years 5.98 d. Based on the information about the corporate bond provided in part b, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds. Round your answers to two decimal places. Years Treasury yield AA-corporate yield 1 5.42% 2 5.47% 3 5.66% 4 5.72% 5 5.65% 10 5.77% 20 6.35% 30 5.98% % % % % % % % % f. Using the Treasury yield information in part c, calculate the following rates using geometric averages (round your answers to three decimal places): 1. The 1-year rate, 1 year from now % 2. The 5-year rate, 5 years from now % 3. The 10-year rate, 10 years from now % 4. The 10-year rate, 20 years from now %
