Question

Which of the following interest rate components could explain the difference in market returns between the 3-year US Treasury and the 10-year US BB Corporate bonds? Select all that apply. Bond Type 3-Year 10-Year US Treasury 0.1662% 0.7022% US AA Corporate 0.4007% 1.4961% US BBB Corporate 0.9014% 2.1876% US BB Corporate 3.1120% 4.8348% Argentina Sovereign 151.8983% 83.7781% Venezuela Sovereign 178.8385% 89.8359% A. Maturity risk premium B. Liquidity premium C. Default risk premium

Answer #1

The difference between a 10- year BB corporate bond and a Treasury bond is :

- Maturity risk premium : the difference in the 10 year duration of US BB corporate bonds and 3 year treasury bond.
- Liquidity premium : there can be a lack of marketability and liquidity of these bonds.
- Default risk premium : as the bonds is BB, AAA and AA rated bonds so there is a risk of default in these bonds in comparison to the treasuries.

So, the correct option is option A,B and C.

Calculating interest rates
The real risk-free rate (r*) is 2.8% and is expected to remain
constant. Inflation is expected to be 7% per year for each of the
next four years and 6% thereafter.
The maturity risk premium (MRP) is determined from the formula:
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premium (LP) on all Gauge Imports Inc.’s bonds is 1.05%. The
following table shows the current relationship between bond ratings
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The maturity risk premium (MRP) is determined from the formula:
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following table shows the current relationship between bond ratings
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show all works
1. The real risk-free rate of interest is 1%. Inflation is
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2. The real risk-free rate of interest is 2.5%. Inflation is
expected to be 2% the next 2 years and 4% during the next 3 years
after that. Assume that the...

The real risk-free (r*) is 2.8% and is expected to remain
constant. Inflation is expected to be 4% per year for each of the
next four years and 3% thereafter.
The maturity risk premium (MRP) is determined from the formula:
0.1(t-1)% where t is the security's marturity. The liquidity
premium (LP) on all Moq Computer Corp's bonds is 1.05%. The
following table shows the current relationship between bond ratings
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US Treasury -
AAA .60%
AA...

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Problem 6-17
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