Interest Rate Premiums. A 5-year Treasury bond has a 5.2% yield. A 10-year Treas

Question

Interest Rate Premiums. A 5-year Treasury bond has a 5.2% yield. A 10-year Treasury bond yields 6.4%, and a 10-year corporate bond yields 8.4%. The market expects that inflation will average 2.5% over the next 10 years(IP10 = 2.5%) Assume that there is no maturity risk premium (MRP=0) and that the annual real risk free rate, r*, will remain constant over the next 10 years. (Hint: Remember that the default risk premium and the liquidity premium are zero for Treasury securities: DRP=LP=0). A 5-year corporate bond has the same default risk premium and liquidity premium as the 10-year corporate bond described. What is the yield on this 5-year corporate bond?

Explanation / Answer

K T-10 = 6.4%; kC-10 = 8.4%; LP =?; DRP = ? k = k* + IP + DRP + LP + MRP. K T-10 = 6.4% = k* + IP + MRP; DRP = LP = 0. K C-10 = 8.4% = k* + IP + DRP + LP + MRP. But we know from above that k* + IP + MRP = 6.4%; therefore, K C-10 = 8.4% = 6.4% + LP + DRP 2% = LP + DRP. K T-5 = 5.2% = k* + IP + MRP; DRP = LP = 0. K C-5 = k* + IP + MRP + DRP + LP = 5.2% + 2% = 7.7%

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