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 0.90% 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.
A)1.75%
B)1.84%
C)1.93%
D)2.03%
E)2.13%

Question

Quizplus · Accepted Answer

The rate of return on a 10-year A-rated corporate bond would be 1.75% higher than on a 5-year Treasury bond. This is because the corporate bond has a longer maturity, which means it is subject to more interest rate risk. Additionally, the corporate bond is rated A, which means it is considered to be a riskier investment than a Treasury bond. As a result, the corporate bond must offer a higher rate of return in order to attract investors.

Suppose the Real Risk-Free Rate Is 3