You read in the Financial Times that 90-day Treasury bills are currently yielding 6.5% and 5-year Treasury bonds are yielding 7.75%. You have got the following estimates current interest rate premium which expected to be constant in the coming five years.

Inflation Premium. IP = 3.25%

Maturity Risk Premium. MRP = 1.8%

Liquidity Premium. LP = 0.6%

Default Risk Premium. DRP = 2.15%

1) What is the real risk-free rate of return on T-bill and T-bond?

T-bill is a short term security, that means LP = 0, MRP = 0, DRP = 0.Then,

Nominal rate or Quoted rate (K) = Real risk-free rate of return (K*) + Inflation Premium (IP)

K = K* + IP

Real risk-free rate of return (K*) = Nominal rate (K) - Inflation Premium (IP)

K* = K – IP

K* = 6.5% – 3.25%

K* = 3.25%

T-bond is a long term security, that means LP = 0, DRP = 0. Then,

Nominal rate (K) =

Real risk-free rate of return (K*) + Inflation Premium (IP) + Maturity Risk Premium (MRP)

K = K* + IP + MRP

Real risk-free rate of return = K* = K – (IP + MRP) K* = 7.75% – (3.25% + 1.8%) K* = 7.75% – 5.05% K* = 2.7%

2) If the KAT company decided to issue 1-year bonds and 5-years bonds. At the same conditions listed above, what are the nominal rate and real rate of these bonds?

1-year bond is a short term security, that means MRP = 0 . then,

Nominal or (Quoted) rate of return on this bond (K) =

Real risk-free rate of return (K*) + Inflation Premium (IP) + Liquidity Premium (LP) + Default Risk Premium (DRP) K = K* + IP + LP + DRP

K = 3.25% + 3.25% + 0.6% + 2.15%

K = 9.25%

The real rate of return on this bond = Nominal rate (K) – Inflation Premium (IP) = K - IP