Question

1-year Treasury bill yield is 3.5%. 10-year Treasury bond yield is 4.5%. Expected rate of inflation embedded in both the Treasury bill and bond is 2.0%. Average yield on AAA-rated 10-year corporate bonds is 5.75%. Average yield on BB-rated 10-year corporate bonds is 8%. Liquidity premium on both Treasury bill and bond is zero. Liquidity premium on both AAA-rated and BB-rated bonds are 0.5%. What is the maturity risk premium embedded in the 10-year Treasury bond

Answer 1

Answer: 2.5%

Explanation:

Treasury bonds have no default risk as they are backed by the U.S. government. The premiums that make up the yield are the inflation, liquidity and maturity risk premiums.

Required yield on Treasury bond = Inflation premium + Liquidity premium + Maturity risk premium

4.5% = 2% + 0% + Maturity risk premium

MRP = 4.5% - 2% - 0%

= 2.5%