The real risk-free rate, r*, is 2.6%. Inflation is expected to average 2.25% per year for the next 4 years, after which time it is expected to average 3.75%, forever.

The real risk-free rate, r*, is 2.6%. Inflation is expected to average 2.25% per year for the next 4 years, after which time it is expected to average 3.75%, forever. An 8-year corporate bond Issued by the Vondrell Corporation will yield 9.5%, which includes a maturity risk premium of 0.20 x (t – 1)%, where t is the bond maturity in years. Assume there is no liquidity premium on Vondrell bonds. What is the yield spread between Vondrell and an 8-year Treasury Security?

Expert Solution

1.Yield of 8-year treasury security
Real Risk-Free Rate = 2.6%
Real Risk-Free Rate after 4 years (adjusted to inflation) = 2.6% (1 + 0.0225)⁴ = 2.842%
Inflation after 4 years = 3.75%
Yield = 2.842 (1 + 0.0375)⁴ = 3.293

2.Yield of 8-year corporate bond
Corporate Bond Yield = 9.5%
Maturity Risk Premium = 0.20 x (t – 1)% where t=8, Therefore MRP = 0.20 x (8-1)% = 1.4%
Corporate Bond Yield after adjusting MRP = 9.5% + (9.5% * 1.4%) = 9.5% + 0.133 = 9.633%

3. Yield spread between Vondrell and an 8-year Treasury Security
9.633- 3.293 = 6.34%

jeff jeffy answered 2 years ago

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