A 5-year Treasury bond has a 5.2% yield. A 10-year Treasury bond yields 6.4%, an

Question

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) ans that the annual real risk-free rate, r*, will remain constant over the next 10 years. (Hint: Remember that the default risk premium ans the liquidity premium are zero for Treasury securities: DRP=LP=0.) A 5-year corporate bond has the same defult risk premium ans liquidity premium as the 10-year corporate bond described. What is the yield on this 5-year corporate bond?

Explanation / Answer

Solution: Here we have: K T-10 = 5.2%; kC-10 = 6.4%; LP =?; DRP = ? As we know that: k = k* + IP + DRP + LP + MRP. K T-10 = 5.2% = k* + IP + MRP; DRP = LP = 0. K C-10 = 6.4% = k* + IP + DRP + LP + MRP. As we know by taking into account above that: => k* + IP + MRP = 5.2% We can write: K C-10 = 6.4% = 5.2% + LP + DRP => 1.2% = LP + DRP. Now: K T-5 = 5.2% = k* + IP + MRP; DRP = LP = 0. As from above figures: K C-5 = k* + IP + MRP + DRP + LP = 5.2% + 1.2% = 6.4% Ans Please rate

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