Help with EOC question: Cap Mkt Expt pg 119, Prob 3

Hi Would someone pls be able to help me with the above question? the solution is on page 119 in book 3 - capital market expectations I would think that the 10-year MBS instrument would need an additional 1% premium over the 1-year US T-Note (making the total expected return for the instrument = 5.75%), in order to compensate for the maturity being 10 years and not 1 year. A similar approach has been utilised for the 10-year corp bond, where premiums for tenure, credit risk, and callability have been added. This hasn’t been covered in Errata either. Am I missing something? H

I don’t think your assumption would be correct if the question didn’t already provide you that “this spread (referring to the MBS prepayment risk spread) includes a maturity premium in relation to the 1-yr T-note as well as compensation for prepayment risk.” Since the 95bps already captures the duration gap, the answer of 4.75% make sense = 1.2 (rf rate) + 2.6% (expected inflation) + 0.95 (spread).

Much thanks xelak73. Although it seems pretty obvious now, I had to see ur response to realise this!

Jeez, they put a centrally important fact in a fine-print footnote!? Cruel

I was reviewing this last night and I have a follow up to this… Q3b.) the spread on the corporate, i thought it would be 1.7 not 2.7 (the answer), it seems as if they are calculating the spread to the 1 year risk free when it should be the 10 year, right? I always thought risk premium you used comparable maturity instruments, 10 year corporate, 10 year treasury… Shouldnt the spread be 6.5 (yield corp) minus 4.8 (yield 10 year), or similarly … 0.9 (credit spr risk over 10 yr treasury) + 0.8 (10 yr call risk) ??

I agree. Simply put, it seems to be like for the corporate bond they are measuring the spread vs. the 1 year Tnote. I think it should be 6.5% of corporate minus 4.8% of 10 year…given that 4.8% comes from 1.2% real risk free rate + 2.6% inflation expectation + 1% of 10 yr spread over 1 year rate? Thoughts?

…and also, in the answer on Page 120, why do they subtract 1 from 1.22%? I’m so ready for this insanity to end.