Assume that r* = 1.0%;the maturity risk premium is found as MRP = 0.2%(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 is 0.50% for AT&T bonds but zero for Treasury bonds;and inflation is expected to be 7%,6%,and 5% during the next three years and then 4% thereafter.What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds?

Question

Quizplus · Accepted Answer

The difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds can be calculated by considering the default risk premium (DRP), the liquidity premium (LP), and the maturity risk premium (MRP) for AT&T bonds, since Treasury bonds do not have DRP or LP and both types of bonds would have the same MRP. For a 10-year bond, the DRP = 0.07%(10 - 1) = 0.63%, the LP = 0.50%, and the MRP does not contribute to the difference since it affects both types of bonds equally. Therefore, the total difference = DRP + LP = 0.63% + 0.50% = 1.13%.

Assume That R* = 1