A 5-year Treasury bond has a 5 - JustAnswer



A 5-year Treasury bond has a 5.2 percent yield. A 10-year Treasury

bond yields 6.4 percent, and a 10-year corporate bond yields 8.4 percent. The market

expects that inflation will average 2.5 percent over the next 10 years (IP10 _ 2.5%).

Assume that there is no maturity risk premium (MRP _ 0), and that the annual real riskfree rate, r*, will remain constant over the next 10 years. (Hint: Remember that the default risk premium and the liquidity premium are zero for Treasury securities: DRP _ LP _ 0.)

A 5-year corporate bond has the same default risk premium and liquidity premium as the

10-year corporate bond described above. What is the yield on this 5-year corporate bond?

Yield on Bond = Risk Free Rate + Inflation Premium + Maturity Risk Premium + Default Risk Premium + Liquidity Premium

For the treasury bonds Default Risk Premium = 0, and Liquidity Premium = 0

Therefore for the 5-year Treasury Bond:

5.2 = Risk Free Rate = Inflation Premium

Since Inflation = 2.5%

Therefore the risk free rate = 5.2 – 2.5 = 2.7%

For the 10- year Treasury bond:

6.4 = Risk Free Rate + Inflation Premium

Risk Free Rate = 6.4 – 2.5 = 3.9%

For the 10-Year Corporate Bond

8.4 = 3.9 + 2.5 + Maturity Risk Premium + Default Risk Premium + Liquidity Premium

Maturity Risk Premium + Default Risk Premium + Liquidity Premium = 8.4 – 3.9 – 2.5

= 2%

Since there is no Market Risk Premium, then:

Default Risk Premium + Liquidity Premium = 8.4 – 3.9 – 2.5

= 2%

For the 5-year Corporate Bond:

Yield on Bond = 2.7 + 2.5 + 2

= 7.2%

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