Suppose you are considering two possible investment opportunities: a 12-year
Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate
is 4%, and inflation is expected to be 2% for the next 2 years, 3% for the following
4 years, and 4% thereafter. The maturity risk premium is estimated by this formula:
MRP = 0.02(t - 1)%. The liquidity premium (LP) for the corporate bond is estimated
to be 0.3%. You may determine the default risk premium (DRP), given the
company’s bond rating, from the table below. Remember to subtract the bond’s LP
from the corporate spread given in the table to arrive at the bond’s DRP. What
yield would you predict for each of these two investments?
Rate
Corporate Bond Yield
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