# Capital Market Expectations

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% ?

Thanks,

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.

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).

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

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

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

Thanks Nova.

I went back to this q and I still do not see clearly why ! % is deducted from 1.22?

take a big magnifying glass see what is on the footnote, then read what I have written above …

When they calculate expected return for 1 year T-Note, they use real return + long term inflation expectation instead of real return + current inflation rate

Thanks

you never use the current inflation rate because it does not mean anything from a longer term perspective…

Thank you.

Alternatively, to make additional investment expected spread / premium of equally weighted investment should be at least 0.5% over 10yr Treasury bond and this could be solved as follows:

= 5.02 % (answer in A) minus (1.2% + 2.6% + 1%)

= 0.22%

these EOCs are bullshit