A 5-year Treasury bond has a 5.2% yield. A 10-year Treasury bond yields 6.4%, an

Question

A 5-year Treasury bond has a 5.2% yield. A 10-year Treasury bond yields 6.4%, and a 10-year corporate bond yields 8.4%. The market expects that inflation will average 2.5% over the next 10 years (IP10=2.5%). Assume that there is no maturity risk premium (MRP=0) ans that the annual real risk-free rate, r*, will remain constant over the next 10 years. (Hint: Remember that the default risk premium ans the liquidity premium are zero for Treasury securities: DRP=LP=0.) A 5-year corporate bond has the same defult risk premium ans liquidity premium as the 10-year corporate bond described. What is the yield on this 5-year corporate bond?

Explanation / Answer

Default risk premium and liqudity premium = 8.4%-6.4% = 2% Yield on 5-year corporate bond = 5.2+2 = 7.2%

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