Question

The real rate of interest has been estimated to be 4 percent, and the expected long-term annual inflation rate is 7 percent. Round your answers to the nearest whole number.

a. What is the current risk-free rate of return on 1-year Treasury bonds? %
b. If the vield on 10-year U.S. Treasury bonds is 14 percent, what is the maturity risk premium between a 10-year bond and a 1-year bond? %
c. If Delta bonds, scheduled to mature in 10 years, currently sell to yield 15 percent, what is the default risk premium on these bonds? %
d. If investors in the common stock of Delta require a 16 percent rate of return, what is the seniority risk premium on Delta's common stock? %

Answer 1

a. The current risk-free rate of return on 1-year Treasury bonds is -3%. b. The maturity risk premium between a 10-year bond and a 1-year bond is 17%. c. The default risk premium on Delta bonds is 18%. d. The seniority risk premium on Delta's common stock is 19%.

Step-by-step explanation:

a. To find the current risk-free rate of return on 1-year Treasury bonds, we subtract the expected long-term annual inflation rate from the real rate of interest. In this case, the inflation rate is 7% and the real rate of interest is 4%, so the risk-free rate of return on 1-year Treasury bonds is 4% - 7% = -3%. Rounded to the nearest whole number, the risk-free rate of return is -3%.

b. The maturity risk premium is the difference between the yield on 10-year U.S. Treasury bonds and the risk-free rate of return on 1-year Treasury bonds. Given that the yield on 10-year U.S. Treasury bonds is 14% and the risk-free rate of return on 1-year Treasury bonds is -3%, the maturity risk premium is 14% - (-3%) = 17%. Rounded to the nearest whole number, the maturity risk premium is 17%.

c. The default risk premium can be calculated by subtracting the risk-free rate of return from the yield on Delta bonds. Given that the yield on Delta bonds is 15% and the risk-free rate of return is -3%, the default risk premium is 15% - (-3%) = 18%. Rounded to the nearest whole number, the default risk premium is 18%.

d. The seniority risk premium can be calculated by subtracting the risk-free rate of return from the rate of return required by investors in the common stock of Delta. Given that investors require a rate of return of 16% and the risk-free rate of return is -3%, the seniority risk premium is 16% - (-3%) = 19%. Rounded to the nearest whole number, the seniority risk premium is 19%.