Suppose the real risk-free rate is 4.20%, the average future inflation rate is 3.55%, and...
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Suppose the real risk-free rate is 4.20%, the average future inflation rate is 3.55%, and a maturity risk premium of 0.08% per year to maturity applies to both corporate and T-bonds, i.e., MRP = 0.08%(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 1.90% 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.
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