1. A particular security’s equilibrium rate of return is 8 percent.

For all securities, the inflation risk

premium is 1.75 percent and the real risk-free rate is 3.5 percent. The security’s liquidity risk
premium is 0.25 percent and maturity risk premium is 0.85 percent. The security has no special
covenants. Calculate the security’s default risk premium.

I* = IP + RFR + DRP + LRP + SCP + MRP

8% = 1.75% + 3.5% + DRP + .25% + 0 + .85%

DRP = 8% - 1.75% - 3.5% - .25% - .85%

DRP = 1.65 %

2. Dakota Corporation 15-year bonds have an equilibrium rate of return of 8 percent. For all
securities, the inflation rate is 3.50 percent. The security’s liquidity risk premium is 0.25 percent
and maturity risk premium is 0.85 percent. The security has no special covenants. Calculate the
bond’s default risk premium.

I* = IP +RFR + DRP + LRP + SCP + MRP

8% = 3.50% + 0 + DRP + .25% + 0 + .85%

DRP = 8% - 3.50% - .25% - .85%

DRP = 3.4 %

3. Tom and Sue’s Flowers Inc.’s 15-year bonds are currently yielding a return of 8.25 percent. The
expected inflation premium is 2.25 percent annually and the real risk-free rate is expected to be
3.50 percent annually over the next 15 years. The default risk premium on Tom and Sue’s
Flowers’ bonds is 0.80 percent. The maturity risk premium is 0.75 percent on 5-year securities
and increases by 0.04 percent for each additional year to maturity. Calculate the liquidity risk
premium on Tom and Sue’s Flowers Inc.’s 15-year bonds.

I* = IP + RFR + DRP + LRP + [MRP + (Rate of increase x 10)]

8.25% = 2.25% + 3.50% + .80% + LRP + [.75% + (.04% x 10)]

LRP = 8.25% - {2.25% + 3.50% + .80% + [.75% + (.04% x 10)]}

LRP = 8.25% - (6.55% + 1.15%)

LRP = 8.25% - 7.70%

LRP = .55%

4. The current one-year Treasury-bill rate is 5.2 percent and the expected one-year rate 12 months
from now is 5.8 percent. According to the unbiased expectations theory, what should be the
current rate for a two-year Treasury security?

1 + 1R2 = [(1 + .052) (1 + .058)] ½

 R = [(1.113016) ½] – 1
1 2

R
1 2= 1.0550 – 1

R
1 2= .0550 or 5.50%

5. One-year Treasury bills currently earn 3.45 percent. You expect that one year from now, one-
year Treasury bill rates will increase to 3.65 percent. If the unbiased expectations theory is
correct, what should the current rate be on two-year Treasury securities?

1 + 1R2 = [(1 + .0345) (1 + .0365)] ½

R = [(1.07225925) ½] – 1
1 2

R = 1.035499517 -1
1 2

R 0.355 or 3.55%
1 2=

6. Suppose we observe the three-year Treasury security rate ( 1R3) to be 12 percent, the expected
one-year rate next year—E (2r1)—to be 8 percent, and the expected one-year rate the following
year— E (3r1)—to be 10 percent. If the unbiased expectations theory of the term structure of
interest rates holds, what is the one-year Treasury security rate?

1.12 = {(1 + 1R1) (1 + E (2r1)) (1 + E(3r1))} 1/3

1.12 = = {(1 + 1R1) (1.08) (1 + 1.10)}1/3

1.123 = (1 + 1R1) (1.08) (1 + 1.10)

1.4049 = (1 + 1R1) (1.08) (1 + 1.10)

1 + 1R1 = 1.4049 / [(1.08) (1.10)]

1 + 1R1 = 1.4049 / 1.188

R = (1.4049 / 1.188) - 1
1 1

R = 18.26%
1 1