The real risk-free rate of interest, r*, is 4%, and it is expected to remain con

Question

The real risk-free rate of interest, r*, is 4%, and it is expected to remain constant over time. Inflation is expected to be 2% per year for the next three years, after which time inflation is expected to remain at a constant rate of 5% per year. The maturity risk premium is equal to 0.1(t - 1)%, where t is the bond’s time to maturity. The liquidity and default risk premia on 10-year corporate bonds are 2.0% and 2.5%, respectively. What is the yield to maturity on a 10-year Treasury bond? A.  8.1% B.  8.9% C.  9.0% D.  12.1% E.  12.3% The real risk-free rate of interest, r*, is 4%, and it is expected to remain constant over time. Inflation is expected to be 2% per year for the next three years, after which time inflation is expected to remain at a constant rate of 5% per year. The maturity risk premium is equal to 0.1(t - 1)%, where t is the bond’s time to maturity. The liquidity and default risk premia on 10-year corporate bonds are 2.0% and 2.5%, respectively. What is the yield to maturity on a 10-year Treasury bond? A.  8.1% B.  8.9% C.  9.0% D.  12.1% E.  12.3%

Explanation / Answer

Average inflation for 10 years = [(3* 2%) + (7 * 5%)]/10 = 4.1%

Market risk premium = 0.1 * (t – 1)% = 0.1 * (10 – 1)% = 0.9%  

rk = r* + Average inflation for 10 years + Market risk premium = 4 + 4.1 + 0.9 = 9%

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