Question 1 Investment Yields [4 points]: One year ago, Melissa purchased 50 shares of common stock for $20 per share. During the year, the value of her stock decreased to $15 per share. If the stock did not pay a dividend during the year, what yield did Melissa earn on her investment?

Question 2 Inflation Premium [4 points]: Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 10 percent, and 9 percent, respectively. What is the inflation premium on a three-year bond (i.e., IP3), and what is the inflation premium on a five-year bond (i.e., IP5)?

Question 3 Inflation and Interest Rate [6 points]: Suppose that inflation currently is about 2 percent. Last year, the Fed took action to maintain inflation at this level. Now, the economy is starting to grow too quickly, and reports indicate that inflation is expected to increase during the next five years. Assume that the rate of inflation expected for the next year (Year 1) is 2 percent; the following year (Year 2) it is expected to be 3 percent; three years from now (Year 3) it is expected to be 5 percent; and every year thereafter, it is expected to settle at 4 percent (Year 4 to Year 5).

a) What was the average expected inflation rate over the next five years (Year 1 through Year 5)?

b) What average nominal interest rate would be expected on five-year Treasury securities, given that the real risk-free rate of return is 2 percent?

Question 4 MRP and DRP [6 points]: Suppose that todays Wall Street Journal reports the yield on Treasury bills maturing in 30 days is 4 percent, the yield on Treasury bonds maturing in 10 years is 6 percent, and the yield on a bond issued by Nextel Communications that matures in six years is 7 percent. Also, today the Federal Reserve announced that inflation is expected to be 2.0 percent during the next 12 months. There is a maturity risk premium (MRP) associated with all bonds with maturities equal to one year or more. Assume Nextels bond is very liquid, and thus it has no liquidity premium.

a) Assume that the increase in the MRP each year is the same and the total MRP is the same for bonds with maturities equal to 10 years and greater that is, MRP is at its maximum for bonds with maturities equal to 10 years and greater. What is the MRP per year?

b) What is the default risk premium associated with Nextels bond.

c) What is the real-risk free rate of return?

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