Suppose the Real Risk-Free Rate Is 3

Multiple Choice

Suppose the real risk-free rate is 3.25%,the average future inflation rate is 4.35%,and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds,i.e.,MRP = 0.07%(t) ,where t is the number of years to maturity.Suppose also that a liquidity premium of 0.50% and a default risk premium of 0.90% apply to A-rated corporate bonds but not to T-bonds.How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? Here we assume that the pure expectations theory is NOT valid.Disregard cross-product terms,i.e.,if averaging is required,use the arithmetic average.

A) 1.75%
B) 1.84%
C) 1.93%
D) 2.03%
E) 2.13%