Suppose the real risk-free rate is 4.00%, the average future inflation rate is 3.50%, and a maturity risk premium of 0.06% per year to maturity applies to both corporate and T-bonds, i.e., MRP = 0.06%(t), where t is the number of years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 2.70% apply to A-rated corporate bonds but not to T-bonds. How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-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.

a. 3.50 p.p.

b. 3.20 p.p.

c. 3.66 p.p.

d. 6.20 p.p.

e. 4.00 p.p.