Suppose the real risk free rate is 3.50%, the average future inflation rate is 2
ID: 2705367 • Letter: S
Question
Suppose the real risk free rate is 3.50%, the average future inflation rate is 2.50%, a maturity premium of 0.02% per year to maturity applies, i.e., MRP = 0.20%(t), where t is the years to maturity. Suppo se also that a liquidity premium of 0.50% and a default risk premium of 1.35% applies to A rated corporate bonds. What is the difference in the yields on a 5 year A rated corporate bond and on a 10 year Treasury bond? Here we assume that the pure expectations theory is NOT valid, and disregard any cross product terms, i.e., if averaging is required, use the arithmetic.Please help
Suppose the real risk free rate is 3.50%, the average future inflation rate is 2.50%, a maturity premium of 0.02% per year to maturity applies, i.e., MRP = 0.20%(t), where t is the years to maturity. Suppo se also that a liquidity premium of 0.50% and a default risk premium of 1.35% applies to A rated corporate bonds. What is the difference in the yields on a 5 year A rated corporate bond and on a 10 year Treasury bond? Here we assume that the pure expectations theory is NOT valid, and disregard any cross product terms, i.e., if averaging is required, use the arithmetic.
Please help
Explanation / Answer
Answer: 0.85%
Real risk-free rate, r* 3.50%
IP 2.50%
MRP, 10-year T-bond Per year: 0.20% Years: 10 2.00%
MRP, 5-year corporate Per year: 0.20% Years: 5 1.00%
LP 0.50%
DRP 1.35%
T-bond yield rT-bond = r* + IP + MRP + DRP + LP 8.00%
A bond yield rCorp = r* + IP + MRP + DRP + LP 8.85%
Difference 0.85%
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