Question

A 5-year Treasury bond has a 3.5% yield. A 10-year Treasury bond yields 6.4%, and a...

A 5-year Treasury bond has a 3.5% yield. A 10-year Treasury bond yields 6.4%, and a 10-year corporate bond yields 9%. The market expects that inflation will average 3.3% over the next 10 years (IP10 = 3.3%). Assume that there is no maturity risk premium (MRP = 0) and that the annual real risk-free 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. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the question below.

Interest rate premiums
5-year Treasury yield (T5) 3.50%
10-year Treasury yield (T10) 6.40%
10-year Corporate yield (C10) 9.00%
Inflation Premium over 10 years (IP10) 3.30%
Maturity Risk Premium (MRP) 0.00%
DRP Treasury 0.00%
LP Treasury 0.00%
DRPC5 + LPC5 = DRPC10 + LPC10
Formulas
Real risk-free rate, r* #N/A
Inflation premium over 5 years (IP5) #N/A
DRP10 + LP10 #N/A
5-year Corporate yield (C5) #N/A
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Homework Answers

Answer #1

Computation of default risk premium + liquidity risk premium

10 year corporate bond yield = 10 year Treasury bond yield + default risk premium + liquidity risk premium

9.00% = 6.40% + default risk premium + liquidity risk premium

default risk premium + liquidity risk premium = 2.60%

5 year Corporate Yield = 5 year treasury B0nd Yield + default risk premium + liquidity risk premium

5 year Corporate Yield = 3.50% + 2.60%

5 year Corporate Yield = 6.10% (Answer)

*Please comment if you face any difficulty and please don't forget to provide positive rating*

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