Objective: Assess students’ understanding of the yield curve, maturity premium (
ID: 2789188 • Letter: O
Question
Objective: Assess students’ understanding of the yield curve, maturity premium (MP), default risk premium (DRP, aka credit spreads), and real interest rate (IRP).
Bond type
2-year
5-year
10-year
Treasury
1.720%
2.070%
2.370%
Municipal Aaa
1.270%
1.508%
1.967%
Municipal Aa
1.252%
Not Available
Not Available
Municipal A
1.327%
1.806%
2.373%
Corporate Aaa
Not Available
Not Available
Not Available
Corporate Aa
1.556%
2.471%
3.030%
Corporate A
2.028%
2.598%
3.168%
Please only answer the questions below as they relate to the table above.
2. Compute estimates of (show your work):
(i) Maturity premium for all three maturities. Do you detect a pattern? If yes, please describe it in your own words
(ii) Default Risk Premium for different credit ratings (you select a maturity). Do you detect a pattern? If yes, please describe it in your own words.
(iv) The 2-year real risk-free rate.
3. Do additional reading / research as required and answer the following questions:
(i). For the same maturity, why is the yield on municipal bonds less than that on Treasury bonds?
(ii) Why is the yield on corporate bonds higher than that on Treasury bonds?
Bond type
2-year
5-year
10-year
Treasury
1.720%
2.070%
2.370%
Municipal Aaa
1.270%
1.508%
1.967%
Municipal Aa
1.252%
Not Available
Not Available
Municipal A
1.327%
1.806%
2.373%
Corporate Aaa
Not Available
Not Available
Not Available
Corporate Aa
1.556%
2.471%
3.030%
Corporate A
2.028%
2.598%
3.168%
Explanation / Answer
Because investors hold the bond for a longer time thereby getting exposed to higher risk which translated to reward.
2. II) - Additional Information required. (However the concept is provided as below)
Annual % yield = (1+coupon rate)Xno. Of years - 1
Default Risk premium = Annual % yield less % inflation less %risk free return less %maturity premium less %bond liqudity premium. Considering a linear realtionship default risk premium shall also follow a relationship of maturity premium.
3.I - Tresury bonds are bonds issues by central bank and it has more wider options to finance ./ pay off nations debt etc. Municipal Bonds are issued by local municipal coproation to fund its infra needs or operational leads. The exposure of money is municpal coproaiton is more transparent and carries lesser risk. hence municapl bond yields are lesser than treasury bonds for the same given period.
3.II - Corporate bonds are bonds issed by corproations and the bonds are used to fund a corporates debt / assets and coupon payments are based on repayment / earining ability of the company. Being risker than treasury bills / bonds the bonds carry a higher coupon rate and have higher yields for the same period to attract more investors.
Answer Maturity Premium for 5 yrs Bond = Yield rate of 5 yrs Maturity Bond - Yield rate of 2 yr Maturity Bond Maturity Premium for 10 yrs Bond = Yield rate of 10 yrs Maturity Bond - Yield rate of 2 yr Maturity Bond Maturity Premium for 10 yrs Bond = Yield rate of 10 yrs Maturity Bond l- Yied rate of 5 yr Maturity Bond Maturity Premium Maturity Premium Wrt to 2 yr bond Wrt to 5 yr bond Bond type 5-year 10-year 10-year Treasury 0.35% 0.65% 0.30% Municipal Aaa 0.24% 0.70% 0.46% Municipal Aa Not Applicable Not Applicable Not Applicable Municipal A 0.48% 1.05% 0.57% Corporate Aaa Not Applicable Not Applicable Not Applicable Corporate Aa 0.92% 1.47% 0.56% Corporate A 0.57% 1.14% 0.57% Note Pattern is Detcted : Higher the maturity period of the bond there shall be more maturity PremiumBecause investors hold the bond for a longer time thereby getting exposed to higher risk which translated to reward.
2. II) - Additional Information required. (However the concept is provided as below)
Annual % yield = (1+coupon rate)Xno. Of years - 1
Default Risk premium = Annual % yield less % inflation less %risk free return less %maturity premium less %bond liqudity premium. Considering a linear realtionship default risk premium shall also follow a relationship of maturity premium.
3.I - Tresury bonds are bonds issues by central bank and it has more wider options to finance ./ pay off nations debt etc. Municipal Bonds are issued by local municipal coproation to fund its infra needs or operational leads. The exposure of money is municpal coproaiton is more transparent and carries lesser risk. hence municapl bond yields are lesser than treasury bonds for the same given period.
3.II - Corporate bonds are bonds issed by corproations and the bonds are used to fund a corporates debt / assets and coupon payments are based on repayment / earining ability of the company. Being risker than treasury bills / bonds the bonds carry a higher coupon rate and have higher yields for the same period to attract more investors.
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