Suppose the real risk-free rate is 5.05%, the average future inflation rate is 4.45%, a maturity premium of 0.08% per year to maturity applies, i.e., MRP = 0.08%(t), where t is the years to maturity. Suppose also that a liquidity premium of 0.5% and a default risk premium of 0.85% applies to A-rated corporate bonds. How much higher would the rate of return be on a 12-year A-rated corporate bond than on a 3-year Treasury bond? Here we assume that the pure expectations theory is NOT valid. Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
Bonds
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