Corporate vs



Corporate vs. Treasury bond yields

1. Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%, a maturity premium of 0.08% per year to maturity applies, i.e., MRP = 0.08%(t), where t is the years to maturity. Suppose also that a liquidity premium of 0.5% and a default risk premium of 0.85% applies to A-rated corporate bonds. How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? Here we assume that the pure expectations theory is NOT valid. Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

a. 1.75%

b. 1.80%

c. 1.85%

d. 1.90%

e. 1.95%

Real risk-free rate, r*

r* = 3.5%

IP = 2.25%

MRP, 5 year T-bond = 0.4% (0.08% per year x 5)

MRP, 10 year corporate = 0.8% (0.08 per year x 10)

LP = 0.5%

DRP = 0.85%

k = r* + IP + MRP

T-Bond Rate = 3.5 +2.25 + 0.4

= 6.15%

k = r* + IP + MRP + LP + DRP

A Bond Yield = 3.5 + 2.25 + 0.8 + 0.5 + 0.85

= 7.9%

Difference = 7.9 – 6.15

= 1.75%

4. Keys Corporation's 5-year bonds yield 6.50%, and T-bonds with the same maturity yield 4.40%. The default risk premium for Keys' bonds is DRP = 0.40%, the liquidity premium on Keys' bonds is LP = 1.70% versus zero on T-bonds, inflation premium (IP) is 1.5%, and the maturity risk premium (MRP) on 5-year bonds is 0.40%. What is the real risk-free rate, r*?

a. 2.10%

b. 2.20%

c. 2.30%

d. 2.40%

e. 2.50%

k = r* + IP + MRP + LP + DRP

6.5 = r* + 1.5 + 0.4 + 1.7 + 0.4

6.5 = r* + 4

r* = 6.5 – 4

= 2.5%

Interest rates

5. Which of the following statements is CORRECT?

a. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond.

b. The real risk-free rate is higher for corporate than Treasury bonds.

c. Most evidence suggests that the maturity risk premium is zero.

d. Liquidity premiums are higher for Treasury than corporate bonds.

e. The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different maturities are driven by expectations about future interest rates.

Estimating the 1-year forward rate

8. Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 6.0%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.4% for a 2-year bond. What is the equilibrium market forecast for 1-year rates 1 year from now?

a. 6.28%

b. 6.39%

c. 6.50%

d. 6.20%

e. 6.72%

Bond yields and prices

9. Which of the following statements is CORRECT?

a. If a bond’s yield to maturity exceeds its coupon rate, the bond’s current yield must be less than its coupon rate.

b. If a bond’s yield to maturity exceeds its coupon rate, the bond’s price must be less than its maturity value.

c. If two bonds have the same maturity, the same yield to maturity, and the same level of risk, the bonds should sell for the same price regardless of the bond’s coupon rate.

d. All else equal, an increase in interest rates will have a greater effect on higher-coupon bonds than it will have on lower-coupon bonds.

e. All else equal, an increase in interest rates will have a greater effect on the prices of short-term bonds than it will on the prices of long-term bonds.

Interest rate vs. reinvestment rate

10. Which of the following statements is CORRECT?

a. A 10-year bond would have more interest rate risk than a 5-year bond, but all 10-year bonds have the same interest rate risk.

b. A 10-year bond would have more reinvestment rate risk than a 5-year bond, but all 10-year bonds have the same reinvestment rate risk.

c. If their maturities and other characteristics were the same, a 5% coupon bond would have more interest rate risk than a 10% coupon bond.

d. If their maturities and other characteristics were the same, a 5% coupon bond would have less interest rate risk than a 10% coupon bond.

e. Any zero coupon bond will have more interest rate price risk than any other type bond, even a perpetuity.

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