A 5-year Treasury bond has a 4.35% yield. A 10-year Treasury bond yields 6.5%, a

Question

A 5-year Treasury bond has a 4.35% yield. A 10-year Treasury bond yields 6.5%, and a 10-year corporate bond yields 9.95%. The market expects that inflation will average 2.85% over the next 10 years (IP10 = 2.85%). 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 above. What is the yield on this 5-year corporate bond? Round your answer to two decimal places.

Explanation / Answer

DRP + LP for 10 year corporate bond = 9.95% - 6.5% = 3.45% Since inflation rate and risk free rate are all constant throughout the 10 years mentioned and 5-year corporate bond has the same default risk premium and liquidity premium as the 10-year corporate bond So, yield on this 5-year corporate bond = yield on 5-year Treasury bond + DRP+LP = 4.35 +3.45 = 7.8%

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