Assume that r* = 2.0%;the maturity risk premium is found as MRP = 0.1%(t − 1)where t = years to maturity;the default risk premium for corporate bonds is found as DRP = 0.05%(t − 1);the liquidity premium is 1.0% for corporate bonds only;and inflation is expected to be 3%,4%,and 5% during the next three years and then 6% thereafter.What is the difference in interest rates between 10-year corporate and Treasury bonds?

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Quizplus · Accepted Answer

The interest rate on a bond can be calculated using the formula: interest rate = r* + IP + MRP + DRP + LP, where r* is the real risk-free rate, IP is the inflation premium, MRP is the maturity risk premium, DRP is the default risk premium, and LP is the liquidity premium.For a 10-year Treasury bond:- r* = 2.0%- IP = Average inflation over 10 years. Given the inflation rates, the average would be (3% + 4% + 5% + 6%*7)/10 = 5.5% (since the first three years are 3%, 4%, and 5%, and then 6% thereafter for 7 years).- MRP = 0.1%(t - 1) = 0.1%(10 - 1) = 0.9%- DRP = 0% (since it's a Treasury bond, there's no default risk premium).- LP = 0% (liquidity premium is not applicable to Treasury bonds).Therefore, the interest rate for the 10-year Treasury bond = 2.0% + 5.5% + 0.9% = 8.4%.For a 10-year corporate bond:- r* = 2.0%- IP = 5.5% (same calculation as above).- MRP = 0.9% (same as above).- DRP = 0.05%(t - 1) = 0.05%(10 - 1) = 0.45%- LP = 1.0%Therefore, the interest rate for the 10-year corporate bond = 2.0% + 5.5% + 0.9% + 0.45% + 1.0% = 9.85%.The difference in interest rates between the 10-year corporate and Treasury bonds = 9.85% - 8.4% = 1.45%.

Assume That R* = 2