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 0.90% 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.
A) 1.75%
B) 1.84%
C) 1.93%
D) 2.03%
E) 2.13%

Question

Quizplus · Accepted Answer

The rate of return on a 10-year A-rated corporate bond is:r_c = r_f + MRP + IP + DRPr_c = 3.25% + 0.07% * 10 + 0.50% + 0.90%r_c = 7.72%The rate of return on a 5-year Treasury bond is:r_t = r_f + MRPr_t = 3.25% + 0.07% * 5r_t = 3.90%The difference in rates is:r_c - r_t = 7.72% - 3.90% = 3.82%

Suppose the Real Risk-Free Rate Is 3