Running head: INVESTMENT ANALYSIS AND FORECAST 1
Investment Analysis and Forecasting
Problem 1 Real Risk-Free Rate Current 30-day T-bills are yielding 3.5 percent. Your accountant provided you with these interest rate premiums: IP = 1.5% LP = 0.6% MRP = 1.8% DFP = 2.15%. What is the real risk-free rate of return based on this data?
| R = 3.5% |
| IP = 1.5% |
| LP =1.5% |
| MRP =1.8% |
| DFP = 2.15% |
| Risk free rate based on the data |
| Solution |
| r= r* + IP |
| 3.5 =r* + 1.5 |
| r* =2.0% |
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Problem 2: Expected Interest Rate For this problem, examine Treasury securities. Considering the following numbers, what would the yield on 3-year Treasury securities be? Real risk-free = 4%. Inflation expected at 1.5% for this year and 2% for the next 2 years. Maturity risk premium = 0.
| r* = 4% |
| Inflation expected at 1.5 for this year and 2% for the next two years |
| Maturity risk premium = 0 |
| r = r* +IP +MRP + DRP + LP |
|
r = 4% + [(1.5 + 2 + 2)]/3 = 5.83% |
Problem 3: Default Risk Premium. A Treasury bond maturing in 5 years has a yield of 4 percent. A 5-year corporate bond has a return of 7 percent. Consider that the liquidity premium on the corporate bond is 0.5 percent. If this is so, what is the default risk on the corporate bond?
Risk free rate of investment = 4%
Corporate bond yield = 7%
Liquidity premium = 0.5%
Default risk = 7 – 4 -0.5 = 2.5%
(Brigham & Houston, 2016; Sherman, 2011).
References
Brigham, E. F., & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA:
Sherman, E. H. (2011). Finance and accounting for nonfinancial managers (3rd ed.). New York, NY: Amacom
