You are given the following data:
$$\begin{array} { l c }
r ^ { * } = \text { real risk-free rate } & 4 \% \
& \
\text { Constant inflation premium (IP) } & 7 \% \
\text { Maturity risk premium (MRP) } & 1 \% \
\text { Default risk premium for AAA bonds (DRP) } & 3 \% \
\text { Liquidity premium for long-term T-bonds (LP) } & 2 \%
\end{array}$$
Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant. Given these conditions, the rate on long-term Treasury bonds is _____.

Question

You are given the following data:
$$\begin{array} { l c } 
r ^ { * } = \text { real risk-free rate } & 4 \% \
& \
\text { Constant inflation premium (IP) } & 7 \% \
\text { Maturity risk premium (MRP) } & 1 \% \
\text { Default risk premium for AAA bonds (DRP) } & 3 \% \
\text { Liquidity premium for long-term T-bonds (LP) } & 2 \%
\end{array}$$
Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant. Given these conditions, the rate on long-term Treasury bonds is _____.

Quizplus · Accepted Answer

The rate on long-term Treasury bonds can be calculated as follows:
Rate on long-term Treasury bonds = r* + IP + MRP + DRP + LP
= 4% + 7% + 1% + 3% + 2%
= 17%
Therefore, the rate on long-term Treasury bonds is 17%. However, in the given problem, it is mentioned that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant. In such a scenario, the liquidity premium for long-term T-bonds (LP) is not applicable, and the rate on long-term Treasury bonds can be calculated as follows:
Rate on long-term Treasury bonds = r* + IP + MRP + DRP
= 4% + 7% + 1% + 3%
= 15%
Therefore, the rate on long-term Treasury bonds is 15%. The closest option is C) 14%, which can be chosen as the best choice.

You Are Given the Following Data Assume That a Highly Liquid Market Does Not Exist for }