Capital Market Expectations

[derswap07]

Hi All,
I was doing the EOC # 3 practice problem for Capital Market Expectations.
For part B, I do not understand why 1% was deducted from 1.20% ?
Help please.
Thanks,

 

[cpk123]

I think it relates to this statement - and footnote
“10-year MBS prepayment risk spread (over 10-year Treasuries)a” = 95 bps
“aThis spread implicitly includes a maturity premium in relation to the 1-year T-note as well as compensation for prepayment risk.”
so “Spread of 10-year over 1-year Treasury note” which is 1% needs to be removed for the 10 yr MBS case.

 

[nova0391]

It relates to whether the investor will invest if the combined risk premium of the three investments is 50bps or greater than 10 year Treasury premium, which is 1%(premium over the T-Bill).
So adding the three investment premiums:
T-Bill=0%
10 yr callable Bond= 1%+.8%+.9%=2.7%
MBS=.95%
So after doing the weighted RP (1.22%), you check whether the investor is getting 50bp premium over the 1%. 1.22-1.00=.22<.50, so decide to not invest

 

[nova0391]

Another Capital Market question.
In question #4, part C…it asks to calculate the expected ERP. I thought you would need to find the expected bond yield instead of the current bond yield by taking the difference in inflation(3.5%-2.6%=.9) and adding it to the current bond yield, to get an expected bond yield of 4.7%(3.8%+.9%).
So expected ERP=expected Equity Return- expected bond yield. However, they use the current bond yield instead…anyone know why this is?
Thanks

 

[MrSmart]

If it’s in real terms, then you use the current bond yield.

 

[derswap07]

Thanks Nova.