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 1.20% 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.

Question

Quizplus · Accepted Answer

First, we need to find the rate of return on a 5-year Treasury bond and a 10-year A-rated corporate bond.

For the 5-year Treasury bond: 
r = r* + IP + MRP 
r = 3.25% + 4.35% + 0.07%(5) 
r = 7.78%

For the 10-year A-rated corporate bond: 
r = r* + IP + MRP + LP + DRP 
r = 3.25% + 4.35% + 0.07%(10) + 0.50% + 1.20% 
r = 9.97%

Now we need to find the difference in rate of return: 
Difference = 9.97% - 7.78% 
Difference = 2.19%

So the answer is closest to option C, which is 2.05%.

Suppose the Real Risk-Free Rate Is 3