HW 1 Solution 1. r* = 3%, I1 = 2%, I2 = 4%, I3 = 4%; for U.S. Treasuries, DRP = LP = 0 a) Find k for 2-yr Treasuries 1) IP will be the average inflation over the next 2 years: IP = (2% + 4%)/2 = 6%/2 = 3% 2) r = r* + IP + DRP + LP + MRP = 3% + 3% + 0 + 0 + 0 = 6% b) Find k for 3-yr Treasuries 1) IP = (2% + 4% + 4%)/3 = 10%/3 = 3.33% 2) r = 3% + 3.33% = 6.33% 2. r* = 3%, I1 = I2 = 3%, r for 2-yr treasuries = 6.2% Find MRP: a) Find IP: IP = (3% + 3%)/2 = 3% b) r = r* + IP + DRP + LP + MRP MRP = r - r* - IP - DRP – LP = 6.2% - 3% - 3% - 0 - 0 = 0.2% 3. 10-yr U.S. Treasury bond, k = 6%. 10-yr Corporate bond, k = 8%, LP = 0.5%; for U.S. Treasuries, DRP = LP = 0 Find DRP on the Corporate bond: Because both bonds have a maturity of 10 years, they will have the same MRP Option 1 (doing all the math in a long, formal way) a) Equation for the treasury bond: rT = r* + IP + DRPT + LPT + MRPT b) Equation for the corporate bond: rC = r* + IP + DRPC + LPC + MRPC c) Since both bonds have the same MRP, we can do this: rT - r* - IP - DRPT - LPT = rC - r* - IP - DRPC - LPC d) Substitute what we know into into the above equation and solve for DRPC 6% - r* - IP – 0 – 0 = 8% - r* - IP – DRPC – 0.5% 6% = 8% - DRPC – 0.5% 6% = 7.5% - DRPC DRPC = 7.5% - 6% = 1.5 % Option 2 (the shorter, more intuitive way) Recall that U.S. Treasury Securities have no DRP and no LRP. Both bonds will have equal MRPs since they have the same maturity. Therefore, the only difference between the two bonds will be in DRP and LP. rC = rT + DRPC + LPC DRPC = rC – rT – LPC = 8% - 6% - 0.5% = 1.5% 4. r* = 3%, I1 = 3%, I2 = 4%, I3-infinity = 3.5%; MRP = 0.0005(t – 1) = 0.05%(t – 1) Find r for a 7-yr U.S. Treasury bond a) Find IP: IP = (3% + 4% + 5(3.5%))/7 = (3% + 4% + 17.5%)/7 = 24.5%/7 = 3.5% b) Find MRP: MRP = 0.05%(t – 1) = 0.05% (7 – 1) = 0.3% c) r = r* + IP + DRP + LP + MRP = 3% + 3.5% + 0 + 0 + 0.3% = 6.8% 5. ROR = (Sale Price – Fair Market Value) / Fair Market Value = ($1050.00 - $1023.68) / $1023.68 = 2.57% 6. You are considering purchasing one of the following securities: ROR Security A = ($10,300.00 - $10,192.56) / $10,192.56 = 1.05% ROR Security B = ($1,200.00 - $1,182.05) / $1,182.05 = 1.52% Security A is most fairly priced

HW 1 Solution 7. U.S. Treasuries Maturity r* Inflation IP DRP LP MRP r 1.0000% 2.0000% 0.0000% 0.2000% 3.2000% 2 2.5000% 2.2500% 0.4000% 3.6500% 3 3.0000% 0.6000% 4.1000% 4 3.5000% 2.7500% 0.8000% 4.5500% 5 2.9000% 4.9000% 6 5.0000% 7 3.0714% 5.0714% 8 3.1250% 5.1250% 9 3.1667% 5.1667% 10 5.2000% 11 3.2273% 5.2273% 12 3.2500% 5.2500% 13 3.2692% 5.2692% 14 3.2857% 5.2857% 15 3.3000% 5.3000% 16 3.3125% 5.3125% 17 3.3235% 5.3235% 18 3.3333% 5.3333% 19 3.3421% 5.3421% 20 3.3500% 5.3500% 21 3.3571% 5.3571% 22 3.3636% 5.3636% 23 3.3696% 5.3696% 24 3.3750% 5.3750% 25 3.3800% 5.3800% 26 3.3846% 5.3846% 27 3.3889% 5.3889% 28 3.3929% 5.3929% 29 3.3966% 5.3966% 30 3.4000% 5.4000% Microspongy Maturity r* Inflation IP DRP LP MRP r 1 1.0000% 2.0000% 0.0500% 0.2000% 3.3000% 2 2.5000% 2.2500% 0.1000% 0.4000% 3.8500% 3 3.0000% 0.1500% 0.6000% 4.4000% 4 3.5000% 2.7500% 0.8000% 4.9500% 5 2.9000% 0.2500% 5.4000% 6 0.3000% 5.6000% 7 3.0714% 0.3500% 5.7714% 8 3.1250% 5.9250% 9 3.1667% 0.4500% 6.0667% 10 3.2000% 0.5000% 6.2000% 11 3.2273% 0.5500% 6.3273% 12 3.2500% 6.4500% 13 3.2692% 0.6500% 6.5692% 14 3.2857% 0.7000% 6.6857% 15 0.7500% 6.8000% 16 3.3125% 6.9125% 17 3.3235% 0.8500% 7.0235% 18 3.3333% 0.9000% 7.1333% 19 3.3421% 0.9500% 7.2421% 20 3.3500% 7.3500% 21 3.3571% 1.0500% 7.4571% 22 3.3636% 1.1000% 7.5636% 23 3.3696% 1.1500% 7.6696% 24 3.3750% 1.2000% 7.7750% 25 3.3800% 1.2500% 7.8800% 26 3.3846% 1.3000% 7.9846% 27 3.3889% 1.3500% 8.0889% 28 3.3929% 1.4000% 8.1929% 29 3.3966% 1.4500% 8.2966% 30 3.4000% 1.5000% 8.4000% Diamond Jim's Maturity r* Inflation IP DRP LP MRP r 1 1.0000% 2.0000% 0.1000% 0.0500% 0.2000% 3.3500% 2 2.5000% 2.2500% 0.4000% 3.9500% 3 3.0000% 0.3000% 0.1500% 0.6000% 4.5500% 4 3.5000% 2.7500% 0.8000% 5.1500% 5 2.9000% 0.5000% 0.2500% 5.6500% 6 5.9000% 7 3.0714% 0.7000% 0.3500% 6.1214% 8 3.1250% 6.3250% 9 3.1667% 0.9000% 0.4500% 6.5167% 10 3.2000% 6.7000% 11 3.2273% 1.1000% 0.5500% 6.8773% 12 3.2500% 1.2000% 7.0500% 13 3.2692% 1.3000% 0.6500% 7.2192% 14 3.2857% 1.4000% 7.3857% 15 3.3000% 1.5000% 0.7500% 7.5500% 16 3.3125% 1.6000% 7.7125% 17 3.3235% 1.7000% 0.8500% 7.8735% 18 3.3333% 1.8000% 8.0333% 19 3.3421% 1.9000% 0.9500% 8.1921% 20 8.3500% 21 3.3571% 2.1000% 1.0500% 8.5071% 22 3.3636% 2.2000% 8.6636% 23 3.3696% 2.3000% 1.1500% 8.8196% 24 3.3750% 2.4000% 8.9750% 25 3.3800% 1.2500% 9.1300% 26 3.3846% 2.6000% 9.2846% 27 3.3889% 2.7000% 1.3500% 9.4389% 28 3.3929% 2.8000% 9.5929% 29 3.3966% 1.4500% 9.7466% 30 3.4000% 9.9000%