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the real risk-free rate is 3%. inflation is expected to be 2% a year for 3...

the real risk-free rate is 3%. inflation is expected to be 2% a year for 3 years, and then 4% a year thereafter. The maturity risk premium is 0.1(t-1)%, where t equals the maturity of the bond. That is, the maturity risk premium on a 5-year bond is 0.004 or 4%. A 5-year corporate bond has a yield of 8.4%. What is the yield on a 7-year corporate bond that has the same default risk and liquidity premiums as the 5-year corporate bond?

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Answer #1

Yield on 5 year bond = Risk free rate+ Inflation premium+maturity risk premium+ (DRP+LP)

8.4%= 3%+(2%*3+4%*2)/5+0.1*(5-1)%+ DRP+LP

DRP+LP= 8.4%-6.2% = 2.2%

Yield on 7 year bond = Risk free rate+ Inflation premium+maturity risk premium+ (DRP+LP)

= 3%+(2%*3+4%*4)/7+ 0.1*(7-1)% + 2.2%

= 8.94%

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