Question

For the following questions, assume the following. The real rate of interest is 2.5%, the maturity risk premium = (t-1)0.1% (where t is time to maturity in years), the liquidity risk premium is 1.4%, and inflation is expected to be 3% each year for the foreseeable future.

a. What would be the yield today on a 10-year U.S. Treasury note that has 5 years to remain until the maturity? b. You find yields for two 5-year corporate bonds, Dell and Gateway. Dell’s yield is 7.5%, and Gateway’s yield is 8.2%. Why are the yields on these 5-year corporate bonds different? Why do the yields on these two corporate bonds differ from the yield on your Treasury bond from the previous question?

c. What is the default risk premium for each bond in question b?

Answer 1

1.
=2.5%+(5-1)*0.1%+1.4%+3%
=7.30%

2.
Yield of corporate bonds might be different because of difference in liquidity and default risk. This can be gauged from difference in bond ratings. Also, any other features such as callability, seniority, secured/unsecured, puttability, convertibility, siking fund provision etc, might lead to difference in yields.

3.
Yield might be different because the corporate bonds have default risk and liquidity risk but Treasury bonds dont have so.

4.
Default risk premium for Dell=7.5%-7.3%=0.2%

Default risk premium for Gateway=8.2%-7.3%=0.9%