5-20-The problem requires you to use File C05 on the computer problem spreadsheet.a.Assume today is January 2, and the expected inflation rates for the next fiveyears are as follows:Year Inflation Rate1 8.0%2 6.03 4.04 3.05 5.0In Year 6 and thereafter, inflation is expected to be 3 percent. The maturityrisk premium (MRP) is 0.1 percent per year to maturity for bonds withmaturities greater than six months, with a maximum MRP equal to2 percent. The real risk-free rate of return is currently 2.5 percent, and it isexpected to remain at this level long into the future. Compute the interest rates on Treasury securities with maturities equal to one year, two years, three years, four years, five years, 10 years, 20 years, and 30 years. Question: I'm not sure what needs to be done on the spreadsheet to get the results. B109BDE97 made up, but it gives us a default relationship with which we are comfortable.98DRP₁ = Default spread * (1.02)(t-1)106 Years to107 Maturity10811092110311141125117 10127137|X✓ fx| =IF(A109<1,"",$D$22)99100101 With all of that having been said, we can step forward and try to construct corporate yield curves.102 Naturally, yield curves can be created for corporate bonds of any rating. However, we have chosen to create curves for103 only AAA and B rated bonds. This exercise is for purely illustrative purposes, so rather than complicate the graph104 with a lot of curves, we will create two curves to show the relationship between yield curves.1052030Real risk-freerate2.00%2.00%2.00%2.00%2.00%2.00%2.00%2.00%147148149 Principles of Finance, 6eInflationPremium (IP)7.00%6.00%5.00%4.50%4.20%3.60%3.30%3.20%Maturity RiskPremium (MRP)0.20%0.40%0.60%0.80%1.00%1.00%1.00%1.00%FTreasuryyield9.20%8.40%7.60%7.30%7.20%6.60%6.30%6.20%AAA-ratingDRP1.50%1.53%1.56%1.59%1.62%1.79%2.19%2.66%AAA-rated B-ratingbond yield DRP4.00%4.08%4.16%4.24%10.70%9.93%H9.16%8.89%8.82%8.39%8.49%8.86%4.33%4.78%5.83%7.10%B-ratedbond yield13.20%12.48%138139 Looking at the yield curve we have constructed, we see a relationship that we should have expected. We see that at any140 length to maturity, the yield on corporate bonds is always greater than the yield on Treasuries. This is logical because141 corporate securities carry a default risk, and Treasuries do not. Furthermore, we observe that at any length to maturity142 the corporate security with the lower rating always has a higher yield than a corporate bond with a higher rating. Once143 again, this is a logical conclusion. Remember, a bond rating, among other things, gives you an indication of the144 expected possibility of default. Naturally, this possibility is greater for bonds with lower ratings, and this possibility of145 default gives the indicated security greater risk. Greater risk should result in a higher yield.14611.76%11.54%11.53%11.38%12.13%13.30%J

Given: Year Inflation rate Maturity risk premium Maximum Maturity risk premium Real risk free…

Answered: 5-20-The problem requires you to use…

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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5-20-The problem requires you to use File C05 on the computer problem spreadsheet.

a.Assume today is January 2, and the expected inflation rates for the next fiveyears are as follows:

Year Inflation Rate

1 8.0%

2 6.0

3 4.0

4 3.0

5 5.0

In Year 6 and thereafter, inflation is expected to be 3 percent. The maturityrisk premium (MRP) is 0.1 percent per year to maturity for bonds withmaturities greater than six months, with a maximum MRP equal to2 percent. The real risk-free rate of return is currently 2.5 percent, and it isexpected to remain at this level long into the future. Compute the interest rates on Treasury securities with maturities equal to one year, two years, three years, four years, five years, 10 years, 20 years, and 30 years.

Question: I'm not sure what needs to be done on the spreadsheet to get the results.

B109
B
D
E
97 made up, but it gives us a default relationship with which we are comfortable.
98
DRP₁ = Default spread * (1.02)(t-1)
106 Years to
107 Maturity
108
1
109
2
110
3
111
4
112
5
117 10
127
137
|X✓ fx| =IF(A109<1,"",$D$22)
99
100
101 With all of that having been said, we can step forward and try to construct corporate yield curves.
102 Naturally, yield curves can be created for corporate bonds of any rating. However, we have chosen to create curves for
103 only AAA and B rated bonds. This exercise is for purely illustrative purposes, so rather than complicate the graph
104 with a lot of curves, we will create two curves to show the relationship between yield curves.
105
20
30
Real risk-free
rate
2.00%
2.00%
2.00%
2.00%
2.00%
2.00%
2.00%
2.00%
147
148
149 Principles of Finance, 6e
Inflation
Premium (IP)
7.00%
6.00%
5.00%
4.50%
4.20%
3.60%
3.30%
3.20%
Maturity Risk
Premium (MRP)
0.20%
0.40%
0.60%
0.80%
1.00%
1.00%
1.00%
1.00%
F
Treasury
yield
9.20%
8.40%
7.60%
7.30%
7.20%
6.60%
6.30%
6.20%
AAA-rating
DRP
1.50%
1.53%
1.56%
1.59%
1.62%
1.79%
2.19%
2.66%
AAA-rated B-rating
bond yield DRP
4.00%
4.08%
4.16%
4.24%
10.70%
9.93%
H
9.16%
8.89%
8.82%
8.39%
8.49%
8.86%
4.33%
4.78%
5.83%
7.10%
B-rated
bond yield
13.20%
12.48%
138
139 Looking at the yield curve we have constructed, we see a relationship that we should have expected. We see that at any
140 length to maturity, the yield on corporate bonds is always greater than the yield on Treasuries. This is logical because
141 corporate securities carry a default risk, and Treasuries do not. Furthermore, we observe that at any length to maturity
142 the corporate security with the lower rating always has a higher yield than a corporate bond with a higher rating. Once
143 again, this is a logical conclusion. Remember, a bond rating, among other things, gives you an indication of the
144 expected possibility of default. Naturally, this possibility is greater for bonds with lower ratings, and this possibility of
145 default gives the indicated security greater risk. Greater risk should result in a higher yield.
146
11.76%
11.54%
11.53%
11.38%
12.13%
13.30%
J

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d)Assume that all the information given previously is the same and the defaultrisk premium for corporate bonds rated AAA is 1.5 percent, whereas it is4 percent for corporate bonds rated B. Compute the interest rates onAAA- and B-rated corporate bonds with maturities equal to one year, twoyears, three years, four years, five years, 10 years, 20 years, and 30 years.

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Question b) Describe the yield curve that is constructed from the results in part (a)

Question c) Rework part (a) assuming one year has passes- that is, today is January q of Year 2. All other information given in part (a) is the same. Rework part (a) again assuming two, three, four, and five years have passed.

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Where does the information on step one comes from?

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