Problem 6-17 Interest Rate Premiums

A 5-year Treasury bond has a 4.45% yield. A 10-year Treasury bond yields 6.4%, and a 10-year corporate bond yields 8.4%. The market expects that inflation will average 2.25% over the next 10 years (IP₁₀ = 2.25%). Assume that there is no maturity risk premium (MRP = 0), and that the annual real risk-free rate, r*, will remain constant over the next 10 years. (Hint: Remember that the default risk premium and the liquidity premium are zero for Treasury securities: DRP = LP = 0). A 5-year corporate bond has the same default risk premium and liquidity premium as the 10-year corporate bond described above. What is the yield on this 5-year corporate bond?

Calculate with at least 4 decimal places on your calculator and round your final answer to two decimal places. For example, if your answer is $345.6671 enter as 345.67 and if your answer is .05718 or 5.718% enter as 5.72 in the answer box provided.