suppose you considering two possible investments oppportunities, 12 year Treasur

Question

suppose you considering two possible investments oppportunities, 12 year Treasury Bond and a 7 year, A rated corporated bond. The current risk free rate is 4%. Inflation is expected to be 2% for the next two years, 3% for the following four years, and 4% thereafter. The maturity risk premium for the corporate bond is estimated to be 0.7%. Finally, you may determine the default risk premium, given the company's bond rating, from the defaullt risk premium table in the text. What yield would you predict for each of these two investments?

Explanation / Answer

Treasury Bond Risk-free rate = 4.00% Maturity: 12 Expected inflation: for the next 2 years = 2% Expected inflation: for the next 4 years = 3% Expected inflation: for the next 6 years = 4% 12 Inflation premium: =((G17*D17)+(G18*D18)+(G19*D19))/D20 = 3.33% Maturity risk premium = =0.1*(C16-1)% = 1.1% 12-year Treasury yield= 8.43% 7-year corporate bond Rating : A Risk-free rate = 4% Maturity: 7 Expected inflation: for the next 2 years = 2% Expected inflation: for the next 4 years = 3% Expected inflation: for the next 1 years = 4% Default Risk from 7 text table: Inflation premium: =((G33*D33)+(G34*D34)+(G35*D35))/D36 = 2.86% Rating DRP AAA 1.0% Maturity risk premium: =0.1*(C32-1)% = 0.60% AA 1.2% Liquidity premium: 0.7% A 1.5% Default risk premium: =IF(B28=H38,I38,IF(B28=H39,I39,IF(ETC.) = 1.5% BBB 1.9% (see screen to right for an alternative way to find the BB+ 3.7% default risk premium.) 7 year Corporate yield= 9.66% Yield Spread = Corporate - Treasury = 1.224% R:econciliation: Default premium 1.500% Liquidity premium 0.700% Inflation premium -0.476% Maturity premium -0.500% 1.224% Maturity Periods Years Yield 3 month 0.25 5.89% 6 month 0.50 6.40% 1 year 1.00 6.32% 2 year 2.00 6.86% 3 year 3.00 6.80% 5 year 5.00 6.71% 10 year 10.00 6.51% 20 year 20.00 6.64% 30 year 30.00 6.22%

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