Risk/Return, Yield Curve, Interest and Inflation Rates
4. Risk and return
Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle's criteria?
AAA bond with 10 years to maturity.
BBB perpetual bond.
BBB bond with 10 years to maturity.
AAA bond with 5 years to maturity.
BBB bond with 5 years to maturity.
5. Yield curve
If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond? The yield on the 10-year bond is less than the yield on a 1-year bond.
The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity premiums.
It is impossible to tell without knowing the coupon rates of the bonds.
The yields on the two bonds are equal.
It is impossible to tell without knowing the relative risks of the two bonds.
7. Interest rates
Assume interest rates on long-term government and corporate bonds were as follows:
T-bond = 7.72% A = 9.64%
AAA = 8.72% BBB = 10.18%
The differences in rates among these issues were caused primarily by:
Default risk differences.
Maturity risk differences.
Answers b and d are correct.
10. Inflation rate
You are given the following data:
r* = real risk-free rate = 4%
Constant inflation premium = 7%
Maturity risk premium = 1%
Default risk premium for AAA bonds = 3%
Liquidity premium for long-term T-bonds = 2%
Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant. Given these conditions, the nominal risk-free rate for T-bills is _____, and the rate on long-term Treasury bonds is _____.
Hint: [rRF = r* + IP]
[r Nom = (r* + IP) + DRP + LP + MRP]