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FM-06 Performance Task 1 Answer Key

The document discusses interest rates and inflation over time. It provides examples of calculating interest rates on Treasury bonds and corporate bonds of different maturities, factoring in the real risk-free interest rate, expected inflation, maturity risk premium, and default risk premium.

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1K views1 page

FM-06 Performance Task 1 Answer Key

The document discusses interest rates and inflation over time. It provides examples of calculating interest rates on Treasury bonds and corporate bonds of different maturities, factoring in the real risk-free interest rate, expected inflation, maturity risk premium, and default risk premium.

Uploaded by

yamamotoakemi24
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
  • Inflation and Interest Rates

BM2213

Inflation and Interest Rates (30 points: 6 items x 5 points)

1. The real risk-free interest rate is 3%, which is expected to remain constant over time. Inflation is expected
to be 2% per year for the next three (3) years and 4% per year for the next five (5) years. The maturity risk
premium equals 0.1 × (𝑡 − 1)%, where t = the bond’s maturity. The default risk premium for a BBB-rated
bond is 1.3%.

a. What is the average expected inflation rate over the next four (4) years?

(2% + 2% + 2% + 4%)
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑣𝑒𝑟 4 𝑦𝑒𝑎𝑟𝑠 = = 𝟐. 𝟓%
4

b. What is the quoted interest rate on a 4-year Treasury bond?

𝑇4 = 𝑟 ∗ + 𝐼𝑃4 + 𝑀𝑅𝑃4 = 3% + 2.5% + 0.1(4 − 1)% = 𝟓. 𝟖%

c. What is the quoted interest rate on a 4-year BBB-rated corporate bond with a liquidity premium of 0.5%?

𝐶4,𝐵𝐵𝐵 = 𝑟 ∗ + 𝐼𝑃4 + 𝑀𝑅𝑃4 + 𝐷𝑅𝑃 + 𝐿𝑃 = 3% + 2.5% + 0.3% + 1.3% + 0.5% = 𝟕. 𝟔%

d. What is the quoted interest rate on an 8-year Treasury bond?

(3 × 2%) + (5 × 4%)
𝑇8 = 𝑟 ∗ + 𝐼𝑃8 + 𝑀𝑅𝑃8 = 3% + + 0.1(8 − 1)% = 3% + 3.25% + 0.7% = 𝟔. 𝟗𝟓%
8

e. What is the quoted interest rate on an 8-year BBB-rated corporate bond with a liquidity premium of
0.5%?

𝐶8,𝐵𝐵𝐵 = 𝑟 ∗ + 𝐼𝑃8 + 𝑀𝑅𝑃8 + 𝐷𝑅𝑃 + 𝐿𝑃 = 3% + 3.25% + 0.7% + 1.3% + 0.5% = 𝟖. 𝟕𝟓%

f. If the quoted interest rate on a 9-year Treasury bond is 7.3%, what does that imply about expected
inflation in nine (9) years?

𝑇9 = 𝑟 ∗ + 𝐼𝑃9 + 𝑀𝑅𝑃9
7.3% = 3% + 𝐼𝑃9 + 0.8%
7.3% − 3% − 0.8% = 𝐼𝑃9
3.5% (3 × 2%) + (5 × 4%) + 𝑋
=
1 9
6% + 20% + 𝑋 = (3.5%)(9)
𝑋 = 31.5% − 6% − 20% = 𝟓. 𝟓%

GRADING RUBRIC:
CRITERIA POINTS
Complete solution with correct answer 5
Half of the solution is correct. 3
First major step of the solution is correct. 1

06 Performance Task 1 Answer Key *Property of STI


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