[KassiusKlay]

I am reposting this question for him!

Hi everybody

Can anyone explain to me why the answer for the following question is a !!??

12. CPAThe

following information is available on market interest rates:

The risk-free rate of interest 2%

Inflation premium 1%

Default risk premium 3%

Liquidity premium 2%

Maturity risk premium 1%

What is the market rate of interest on a one-year U.S. Treasury bill?

a. 3%

b. 5%

c. 6%

d. 7%

Explanation

Choice “a” is correct. ??????????????????????

Form is temporary, class is permanent.

Audit 4/19/12 - 77
BEC 5/31/12 - 75
FAR 8/30/12

[Anonymous]

I found this in a Google search:

https://www.csun.edu/~zz1802/Finance%20303/Lecture-Notes-Mid2.pdf

“The determinants of interest rates

The quoted (nominal) interest rate on a debt security is composed of a real riskfree

rate, r*, plus several risk premiums

Risk premium: additional return to compensate for additional risk

Quoted nominal return = r = r* + IP + DRP + MRP + LP

where, r = the quoted, or nominal rate on a given security

r* = real risk-free rate

IP = inflation premium (the average of expected future inflation rates)

DRP = default risk premium

MRP = maturity risk premium

LP = liquidity premium

and r* + IP = rRF = nominal risk-free rate (T-bill rate)”

It looks like you would add the risk-free rate of interest (2%) and the inflation premium (1%) to get the market rate for a T-bill. Nothing that I read in the Wiley Book or on the internet was worded like the problem. Everything I read referred to the Risk Free Rate and the Nominal Risk Free Rate.

[Anonymous]

That’s exactly correct Kricket. The nominal risk free rate (or market rate) = real risk free rate + inflation rate

A one year U.S. Treasury bill (T-Bill) only reflects the real risk free rate and the inflation rate. The other risk premiums are not appropriate for a U.S. Treasury bill.

T-bills do not have Default Risk Premium since the federal government issues the security and cannot default. They can just print more money and pay the debt. [by printing more money, the federal government can avoid default, but will cause other problems…just google on your own to read why]

T-bills do not have Liquidity Risk Premium since it is easy to trade the securities. Liquidity risk premium is probably more appropriate for a corporate bond which has no trading market (i.e. it’s hard to sell, thus you have no liquidity)

T-bills are short-term by definition and the problem suggests they are one-year. At this time frame, the maturity risk premium is probably zero or very close to it. I thought Figure 6-5 in Kricket’s pdf she linked explained this quite well.

I’ve always worked on the equity side of finance, so if I made a mistake please correct me!

[Anonymous]

@chiwhitesox – Thanks for confirming that. I was so confused when I read it all. Now I get it! I don't think I saw it explained as well as you did on any of the websites that I looked at nor in any of the text books that I looked in. Thank you!!

[Anonymous]

You're welcome! Glad it was helpful!

[Author]

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