Suppose the real risk-free rate is 3.50%, the average future inflation

QUESTION

Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%, a maturity premium of 0.08% per year to maturity applies, i.e., MRP = 0.08%(t), where t is the years to maturity.Suppose also that a liquidity premium of 0.5% and a default risk premium of 0.85% applies to A-rated
Real risk-free rate, r* r* = 3.5% IP = 2.25% MRP, 5 year T-bond = 0.4% (0.08% per year x 5) MRP, 10 year corporate = 0.8% (0.08 per year x 10) LP = 0.5% DRP = 0.85% k = r* IP MRP T-Bond

Rate = 3.5 2.25 0.4 = 6.15% k = r* IP MRP LP DRP A Bond Yield = 3.5 2.25 0.8 0.5 0.85 = 7.9% Difference = 7.9 6.15 = 1.75%

ANSWER:

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