A B C D E F G H I

1 04problem 11/24/2018 18:55 2/10/2003

2
3 Chapter 4. Solution to end-of-chapter spreadsheet problem
4
5 a. Suppose you are considering two possible investment opportunities, a 12-year Treasury bond and a 7-year,
6 A-rated corporate bond. The current real risk-free rate is 4%. Inflation is expected to be 2% for the next
7 two years, 3% for the following four years, and 4% thereafter. The maturity risk premium is estimated by
8 this formula: MRP = 0.1% ( t-1) %. The liquidity premium for the corporate bond is estimated to be
9 0.7%. Finally, you may determine the default risk premium, given the company’s bond rating, from the
10 default risk premium table in the text. What yield would you predict for each of these two investments?
11
12 Treasury Bond
13
14 Risk-free rate = 4.00%
15
16 Maturity: 12
17 Expected inflation: for the next 2 years = 2%
18 Expected inflation: for the next 4 years = 3%
19 Expected inflation: for the next 6 years = 4%
20 12
21 Inflation premium: =((G17*D17)+(G18*D18)+(G19*D19))/D20 = 3.33%
22
23 Maturity risk premium = =0.1*(C16-1)% = 1.1%
24
25 12-year Treasury yield= 8.43%
26
27 7-year corporate bond
28 Rating : A
29
30 Risk-free rate = 4%
31
32 Maturity: 7
33 Expected inflation: for the next 2 years = 2%
34 Expected inflation: for the next 4 years = 3%
35 Expected inflation: for the next 1 years = 4% Default Risk from
36 7 text table:
37 Inflation premium: =((G33*D33)+(G34*D34)+(G35*D35))/D36 = 2.86% Rating DRP
38 AAA 1.0%
39 Maturity risk premium: =0.1*(C32-1)% = 0.60% AA 1.2%
40 Liquidity premium: 0.7% A 1.5%
41 Default risk premium: =IF(B28=H38,I38,IF(B28=H39,I39,IF(ETC.) = 1.5% BBB 1.9%
42 (see screen to right for an alternative way to find the BB+ 3.0%
43 default risk premium.)
44 7 year Corporate yield= 9.66%
45
46 Yield Spread = Corporate - Treasury = 1.224%
47 Reconciliation: Default premium 1.500%
48 Liquidity premium 0.700%
49 Inflation premium -0.476%
50 Maturity premium -0.500%
51 1.224%
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 A B C D E F G H I
53 b. Given the following Treasury bond yield information from a recent publication,
54 construct a graph of the yield curve.
55 Maturity
56 Periods Years Yield
57 1 year 1.00 5.37%
58 2 year 2.00 5.47%
59 3 year 3.00 5.65%
60 4 year 4.00 5.71%
61 5 year 5.00 5.64%
62 10 year 10.00 5.75%
63 20 year 20.00 6.13%
64 30 year 30.00 5.99%
65
66 Now we can use Excel's chart wizard to construct a yield curve.
67
68 Yield Curve
69 7.00%
70
6.00%
71
72 5.00%
73 4.00%
74 3.00%
75 2.00%
76
1.00%
77
78 0.00%
0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00
79
80
81 c. Based on the information about the corporate bond that was given in Part A, calculate yields and then
82 construct a new graph that shows both the Treasury and the corporate bonds.
83
84 The real risk-free rate would be the same for the corporate and treasury bonds. Similarly, without
85 information to the contrary, we would assume that the maturity and inflation premiums would be the same for
86 bonds with the same maturities. However, the corporate bond would have a liquidity premium and a default
87 premium. If we assume that these premiums are constant across maturities, then we can use the LP and DRP
88 premiums as determined above and add them to the T-bond yields to find the corporate yields. This procedure
89 was used in the table below.
90
91 Years Treasury A-Corporate Spread LP DRP
92 1.00 5.37% 7.57% 2.20% 0.7% 1.5%
93 2.00 5.47% 7.67% 2.20% 0.7% 1.5%
94 3.00 5.65% 7.85% 2.20% 0.7% 1.5%
95 4.00 5.71% 7.91% 2.20% 0.7% 1.5%
96 5.00 5.64% 7.84% 2.20% 0.7% 1.5%
97 10.00 5.75% 7.95% 2.20% 0.7% 1.5%
98 20.00 6.13% 8.33% 2.20% 0.7% 1.5%
99 30.00 5.99% 8.19% 2.20% 0.7% 1.5%
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101 Now we can graph the data in the first 3 columns of the above table to get the Treasury and corporate (A-rated)
102 yield curves:
103
104
Treasury and Corporate Yield Curves
105
106 9.00%
107 8.00%
108
7.00%
109
110 6.00%
Treasury
111 5.00%
112 A-Corporate
4.00%
113
114 3.00%
115 2.00%
116 1.00%
117
0.00%
118
0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00
119
120
121 Note that if we constructed yield curves for corporate bonds with other ratings, the higher the rating, the
122 lower the curves would be. Note too that the DRP for different ratings can change over time as investors' (1)
123 risk aversion and (2) perceptions of risk change, and this can lead to different yield spreads and curve
124 positions. Expectations for inflation can also change, and this will lead to upward or downward shifts in all
125 the yield curves.
126
127 d. Using the Treasury yield information above, calculate the following forward rates:
128
129 (1) The 1-year rate, one year from now. r
1 1

130 (2) The 5-year rate, five years from now. r

5 5

131 (3) The 10-year rate, ten years from now. r

10 10

132 (4) The 10-year rate, twenty years from now. r

20 10

133
134 Maturity Maturity Yield
135 in years
136 1 year 1 5.37%
137 2 year 2 5.47%
138 3 year 3 5.65%
139 4 year 4 5.71%
140 5 year 5 5.64%
141 10 year 10 5.75%
142 20 year 20 6.13%
143 30 year 30 5.99%
144
145 (1) The 1-year rate, one year from now.
146 r2 = ( r1 + r
1 1 ) / 2
147 5.47% = ( 5.37% + r
1 1 ) / 2
148 5.57% = r
1 1

149
150 (2) The 5-year rate, five years from now.
151 r10 = ( r5 + r
5 5 ) / 2
152 5.75% = ( 5.64% + r
5 5 ) / 2
153 5.86% = r
5 5

154
155 (3) The 10-year rate, ten years from now.
156 r20 = ( r10 + r
10 10 ) / 2
157 6.13% = ( 5.75% + r
5 5 ) / 2
158 6.51% = r
5 5

159
160 (4) The 10-year rate, twenty years from now.
161 r30 = ( 2 x r20 + r
20 10 ) / 3
162 5.99% = ( 12.26% + r
20 10 ) / 3
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163 5.71% = r
20 10