Suppose that today’s Wall Street Journal reports the yield on Treasury bills maturing in 30 days is 3.5 percent, the yield on Treasury bonds maturing in 10 years is 6.5 percent, and the yield on a bond issued by Nextel Communications that matures in six years is 7.5 percent. Also, today the Federal Reserve announced that inflation is expected to be 2.0 percent during the next 12 months. There is a maturity risk premium (MRP) associated with all bonds with maturities equal to one year or more.
a. Assume that the increase in the MRP each year is the same and the total MRP is the same for bonds with maturities equal to 10 years and greater—that is, MRP is at its maximum for bonds with maturities equal to 10 years and greater. What is the MRP per year?
b. What is the default risk premium associated with Nextel’s bond?
c. What is the real risk-free rate of return?