Suppose the real risk-free rate is 3.25%,the average future inflation rate is 4.35%,and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds,i.e. ,MRP = 0.07%(t),where t is the number of years to maturity.Suppose also that a liquidity premium of 0.50% and a default risk premium of 2.50% apply to A-rated corporate bonds but not to T-bonds.How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? Here we assume that the pure expectations theory is NOT valid.Disregard cross-product terms,i.e. ,if averaging is required,use the arithmetic average.

Question

​Suppose the real risk-free rate is 3.25%,the average future inflation rate is 4.35%,and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds,i.e. ,MRP = 0.07%(t),where t is the number of years to maturity.Suppose also that a liquidity premium of 0.50% and a default risk premium of 2.50% apply to A-rated corporate bonds but not to T-bonds.How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? Here we assume that the pure expectations theory is NOT valid.Disregard cross-product terms,i.e. ,if averaging is required,use the arithmetic average.

Quizplus · Accepted Answer

The rate of return on a 10-year A-rated corporate bond is:r = 3.25% + 4.35% + 0.07% * 10 + 0.50% + 2.50% = 10.67%The rate of return on a 5-year Treasury bond is:r = 3.25% + 4.35% + 0.07% * 5 = 7.92%The difference between the two rates is:10.67% - 7.92% = 2.75%However, we are asked to disregard cross-product terms, so the difference is:2.75% - 0.07% * 5 = 1.90%

​Suppose the Real Risk-Free Rate Is 3

Suppose the Real Risk-Free Rate Is 3