Suppose the real risk free rate is 3.50, inflation next year is expected to be 1.5, 2.5 two years...

Question:

Suppose the real risk-free rate is 3.50%, inflation next year is expected to be 1.5%, 2.5% two years from now and 3% thereafter. There is a maturity premium of 0.2% per year to maturity i.e., MRP = 0.20% t, where t is the years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 1.35% exist.

What is the yield on a 5-year A-rated corporate bond and on a 10-year Treasury bond?

Interest rates

The nominal interest rate is a function of several factors: the real risk-free rate of interest, the inflation premium, and the maturity risk premium. These three affect all bonds similarly. In addition, liquidity and default risk premium specific to the issuance also affect yields.

The 10 year Treasury bond yield equals:{eq}r=r*+IP+MRP+LP+DRP {/eq}

where r* is the risk free rate, IP is the inflation premium, MRP is the maturity...

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