University of Tunis
Tunis Business School
Principles of Finance
Tutorial n°5: The Determinants of the YTM
Professor: Dr. Ridha Esghaier
(Spring 2023)
Exercise 1
The real risk-free rate is 2%. Inflation is expected to be 3% this year, 4% next year, and then
3.5% thereafter. The maturity risk premium is estimated to be 0.0005 ×(t - 1), where t = number
of years to maturity. What is the nominal interest rate on a 7-year Treasury security?
Exercise 2
Assume that the real risk-free rate, r*, is 3% and that inflation is expected to be 8% in Year 1,
5% in Year 2, and 4% thereafter. Assume also that all Treasury securities are highly liquid and
free of default risk. If 2-year and 5-year Treasury notes both yield 10%, what is the difference in
the maturity risk premiums (MRPs) on the two notes; that is, what is MRP5 minus MRP2?
Exercise 3
Because of a recession, the inflation rate expected for the coming year is only 3%. However,
the inflation rate in Year 2 and thereafter is expected to be constant at some level above 3%.
Assume that the real risk-free rate is r* = 2% for all maturities and that there are no maturity
premiums. If 3-year Treasury notes yield 2 percentage points more than 1-year notes, what
inflation rate is expected after Year 1
Exercise 4
A 5-year Treasury bond has a 5.2% yield. A 10-year Treasury bond yields 6.4%, and a 10-year
corporate bond yields 8.4%. The market expects that inflation will average 2.5% over the next
10 years (IP10= 2.5%). Assume that there is no maturity risk premium and that the annual real
risk-free rate, r*, will remain constant over the next 10 years. A 5-year corporate bond has the
same default risk premium and liquidity premium as the 10-year corporate bond described.
What is the yield on this 5-year corporate bond?
Exercise 5
Suppose you and most other investors expect the inflation rate to be 7% next year, to fall to
5% during the following year, and then to remain at a rate of 3% thereafter.
Assume that the real risk-free rate, r*, will remain at 2% and that maturity risk premiums on
Treasury securities rise from zero on very short-term securities (those that mature in a few days)
to a level of 0.2 percentage points for 1-year securities.
Furthermore, maturity risk premiums increase 0.2 percentage points for each year to maturity,
up to a limit of 1.0 percentage point on 5-year or longer-term T-notes and T-bonds.
a. Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20-year Treasury securities, and plot
the yield curve.
b. Now suppose ExxonMobil’s bonds, rated AAA, have the same maturities as the Treasury
bonds. As an approximation, plot an ExxonMobil yield curve on the same graph with the
Treasury bond yield curve. (Hint: Think about the default risk premium on ExxonMobil’s long-
term versus its short-term bonds.)
c. Now plot the approximate yield curve of Long Island Lighting Company, a risky nuclear
utility.
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