Suppose the real risk-free rate is 3.25%, the average future inflation rate is 4

Question

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 years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 1.00% 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.

Explanation / Answer

Hi,

Please find the detailed answer as follows:

Rate of Return (Corporate Bond) = 3.25 (Risk Free Rate) + 4.35 (Average Inflation Rate) + .07*10 (MRP) + .50 (Liquidity Premium) + 1 (Default Premium)= 9.8%

Rate of Return (T Bonds) = 3.25 (Risk Free Rate) + 4.35 (Average Inflation Rate) + .07*5 (MRP) = 7.95%

Difference = 9.8 - 8.3 = 1.85%

Option C (1.85%) is the correct answer.

Thanks.

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