BUS FPX 4070 Assessment 2 Inflation and Interest Rates

Student Name

Capella University

BUS-FPX4070 Foundations in Finance

Prof. Name

Date

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%

According to Hayes (2021), to calculate the real risk-free rate, subtract the inflation rate (IP) from the yield of the Treasury bond matching your investment duration.

What is the real risk-free rate of return based on this data?

[ r^ = RFR – IP ] [ r^ = 3.5\% – 1.5\% ] [ r^* = 2\% ]

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.

[ Yield = r^ + IP + MRP ] [ r^ = 4\% + \left(\frac{1.5\% + 2\% + 2\%}{3}\right) + 0 ] [ r^* = 4\% + \left(\frac{5.5\%}{3}\right) + 0 ] [ \text{Yield} = 4\% + 1.83\% ] [ \text{Yield} = 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 yield 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?

[ \text{Default risk premium} = \text{corporate yield} – \text{t-bond yield} – IP – LP ] [ DFP = 7\% – 4\% – 0 – 0.5\% ] [ DFP = 3\% – 0.5\% ] [ DFP = 2.5\% ]

References

Brigham. (n.d.). Fundamentals of financial management. Retrieved from [https://capella.vitalsource.com/reader/books/9780357088562/epubcfi/6/36[%3Bvnd.vst.idref%3DM18]!/4/204/9:237[at%20%2Csho](https://capella.vitalsource.com/reader/books/9780357088562/epubcfi/6/36[%3Bvnd.vst.idref%3DM18]!/4/204/9:237[at%20%2Csho)]

Hayes, A. (2021, August 30). Investopedia. Risk-free rate of return. What is the risk-free rate of return? Retrieved from https://www.investopedia.com/terms/r/riskfreerate.asp#:~:text=To%20calculate%20the%20real%20risk,bond%20matching%20your%20investment%20duration.

Motley Fool Staff. (2016, November 2). The Motley Fool. How to find a default risk premium on a corporate bond. Why you should care about a bond’s default risk premium and how to figure it out. Retrieved from https://www.fool.com/knowledge-center/how-to-find-a-default-risk-premium-on-a-corporate.aspx#:~:text=The%20default%20risk%20premium%20is,bond%20you%20wish%20to%20purchase.

BUS FPX 4070 Assessment 2 Inflation and Interest Rates

Corporate Finance Institute. (n.d.). Return on equity. What is return on equity (ROE). Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-return-on-equity-roe/

Divvy. (n.d.). Get Divvy. Business forecasting; Why it’s important. Retrieved from https://getdivvy.com/learn/business-forecasting/

McClure, B. (2021, December 29). Investopedia. How to use ROA to judge a company’s financial performance. Retrieved from https://www.investopedia.com/articles/fundamental/04/012804.asp#:~:text=Return%20on%20assets%20(ROA)%20is,its%20assets%20to%20generate%20profits%20is,its%20assets%20to%20generate%20profits).

Slipka, B. (2019, December 3). Forbes. Let insights reveal new opportunities. Four qualitative factors to consider in a business valuation. Retrieved from https://www.forbes.com/sites/forbesfinancecouncil/2019/12/03/four-qualitative-factors-to-consider-in-a-business-valuation/?sh=24352fe5a1a8

BUS FPX 4070 Assessment 2 Inflation and Interest Rates