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

Real risk-free rate, r* 3.25% IP 4.35% MRP, 5-year T-bond Per year: 0.07% Years: 5 0.35% MRP, 10-year corporatePer year: 0.07% Years: 10 0.70% LP 0.50% DRP 1.00% T-bond yield rT-bond = r* + IP + MRP 7.95% A bond yield rCorp = r* + IP + MRP + DRP + LP 9.80% Higher return 1.85%

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