Assume that real risk-free rate (r*) = 1.00%; the maturity risk premium is found as MRP = 0.20% × (t - 1), where t = years to maturity; the default risk premium for AT&T bonds is found as DRP = 0.07% × (t - 1); the liquidity premium (LP) is 0.50 percent for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7 percent, 6 percent, and 5 percent during the next three years and then 4 percent thereafter. What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds? (Round answer to two decimal places.)
A)0.25%
B)0.50%
C)0.63%
D)1.00%
E)1.13%

Question

Quizplus · Accepted Answer

The difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds is calculated by considering the default risk premium (DRP), liquidity premium (LP), and the fact that Treasury bonds do not have DRP or LP. For AT&T bonds, the DRP at 10 years is 0.07% × (10 - 1) = 0.63%, and the LP is 0.50%. Adding these gives a total of 1.13%. Treasury bonds do not have these premiums, so the difference is 1.13%.

Assume That Real Risk-Free Rate (R*) = 1