difference in interest rates between 10-year AT&T bonds
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Assume that k* = 1.0%; the maturity risk premium is found as MRP = 0.2%(t - 1) where t = years to maturity; the default risk premium for AT&T bonds is found as DRP = 0.07%(t - 1); the liquidity premium is 0.50% for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7%, 6%, and 5% during the next three years and then 4% thereafter. What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds?
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This solution is comprised of a detailed calculation to answer the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds.
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Financial Management
Assume that k* = 1.0%; the maturity risk premium is found as MRP = 0.2%(t - 1) where t = years to maturity; the default risk premium for AT&T bonds is found as DRP = 0.07%(t - 1); the liquidity premium is 0.50% for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7%, 6%, and 5% during the next three years and then 4% thereafter. What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds?
Interest rate = k = k* + IP + DRP + LP + MRP
Where k = interest rate
k* = real risk-free rate
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
Year 1
10-year AT&T bonds
MRP = 0.2%(9 - 1) = 1.6%
DRP = 0.07%(9 - 1) = 0.56%
LP = 0.50%
IP = 7%
k = 1.0% + 7% + 0.56% + 0.50% + 1.6% = 10.66%
10-year ...
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