MODULE 4 Activity 1

Submitted by:
Gregorio, Arnelli Marie
Orhin,Winnie Rose
Mahilum Aionah

7-3 EXPECTED INTEREST RATE

Solution:
Average inflation for the first two years (IP2) and over three years (IP3)
IP2 = (2% + 4%) / 2
= 3%

IP3 = (2% + 4% + 4%) / 3

= 3.33%

Yield on the 2-year Treasury (R2) by adding real-risk free rate and the average
inflation for the first two years
Rt = R* + IP
R2 = 2% + 3%
= 5%

Yield on a 3-year Treasury (R3) by adding real risk-free rate and the average
inflation over three years
R3 = 2% + 3.33%
= 5.33%

2-year T-bond yield = 5%

3-year T-bond yield = 5.33%
 7-6 INFLATION CROSS - PRODUCT

Solution:

4-year treasury yield

= (1 + Real Risk-free rate) x (1 + Inflation rate) - 1

= (1 + 5%) x (1 + 16%) - 1

= (1 + 0.05) x (1+ 0.16) -1

= (1.05) x (1.16) -1

= 1.218 - 1

= 0.218 or 21.8%

7-10 INFLATION

Inflation rate, Year 1 = 3%

Inflation rate, Year 2 and thereafter = 3%
Real risk-free rate (r*) = 2%
3-year Treasury Bond Yield = 2% + 1 Year Yield

T1 = r* + IP1 + MRP1
= 2% + 3% + 0%
= 5%

3-year Treasury Bond Yield = T1 + 2%

= 5% + 2%
= 7%

(1.0575)¹ x (1 + x)² = (1.0725)³

(1 + x)² = (1.0725)³/(1.0575)¹
(1 + x)² = 1.166571941
(square root dayun guys hahaha)
1 + x = 1.0800796
x = 1.0800796 - 1
 x = 0.0800796 or 8.01%

T = r* + IP
8.01% = 2% + IP
IP = 8.01% - 2
IP = 6.01%

10-13 DEFAULT RISK PREMIUM

rc8 = r* + iP8 + MRP8 + DRP8 + LP8

8.3% = 2.5% + (2.8% x 4 + 3.75% x 4)/8 + 0.0% + DRP8 + 0.75%
8.3% = 6.525% + DRP8
DRP8 = 1.775%

7-12. MATURITY RISK PREMIUM An investor in Treasury securities expects

inflation to be 2.5% in Year 1, 3.2% in Year 2, and 3.6% each year thereafter. Assume
that the real risk-free rate is 2.75% and that this rate will remain constant. Three-year
Treasury securities yield 6.25%, while 5-year Treasury securities yield 6.80%. What is
the difference in the maturity risk premiums (MRPs) on the two securities; that is what is
MRP5 - MRP3?

Answer:

IP3 = (2.5%+3.2%+3.6%)/3 = 3.1%

IP5= (2.5%+3.2%+3.6%*3)/5 = 3.3%

Yield on 3-year bond, r3=2.75%+3.1%+MRP3=6.25%, so MRP3=0.4%

Yield on 5-year bond, r5=2.75%+3.3%+MRP5=6.8%, so MRP5=0.75%

Therefore:
MRP5 - MRP3 = 0.75% - 0.4%
= 0.35%
7-14 EXPECTATIONS THEORY AND INFLATION
Suppose 2-year Treasury bonds yield 4.5%, while 1-year bonds yield 3%. r* is 1%, and
the maturity risk premium is zero.

a. Using the expectations theory, what is the yield on a 1-year bond 1 year from now?
Calculate the yield using a geometric average.

Answer:
The expectations theory explains that the short-term interest rates are based on the
long-term interest rates. For example, if a person invests in a 1-year bond and rolls-over
the investment for the further years, it will be equal to the long-term investment.
And pure expectations theory explains that the shape of the yield curve depends on the
expectations of the investor about future expected interest rates.

((1+ yield on 1-year bond) * (1+ yield on 1-year bond one year from now)) = (1+ yield on
2 year bond)2

((1+3%) *(1+ yield on 1-year bond one year from now))= (1+4.5%)2
(1 + yield on 1-year bond one year from now) = (1+0.045)2 / (1+3%)
yield on 1-year bond one year from now = (1+0.045)2 / (1+3%) - 1
= (1.045)2/ (1.03) -1
= 1.09203/ 1.03-1
= 1.06022 -1
=0.6022 or 6.02%

Therefore, the yield on a 1-year bond one year from now is 6.02%.

b. What is the expected inflation rate in Year 1? Year 2?

Answer:
Year 1
((1+risk-free rate)*(1+ Inflation in year 1)) = (1+yield on 1 year bond)
((1+1%)*(1+ Inflation in year 1))= (1+3%)
(1+Inflation in year 1) =(1+3%)/(1+1%)
Inflation in Inflation in year 1 = (1+0.03)/(1+0.01) - 1
= (1.03)/(1.01) - 1
= 1.01980 - 1
= .01980 or 1.98%
Therefore, the inflation in year 1 is 1.98%

Year 2

((1+risk-free rate)*(1+Inflation in year 2)) = (1+ yield on 1 year bond 1 year from now)
((1+1%)*(1+Inflation in year 2))= (1+6.02%)
(1+ Inflation in year 2) = (1+6.02%)/(1+1%)
Inflation in year 2 = (1 +0.0602)/(1+0.01) - 1
=(1.0602)/(1.01) - 1
= 1.0497 - 1
=.0497 or 4.97%

Therefore, the inflation in year 2 is 4.97%