Final answer:
The question revolves around the difference in yields between 10-year Treasury bonds and 10-year AAA-rated corporate bonds, accounting for the liquidity premium of the latter. Corporate bonds offer higher yields to compensate for their higher default risk, whereas Treasury bonds are considered virtually risk-free. Both yields are susceptible to market conditions and can fluctuate accordingly.
Step-by-step explanation:
The student's question involves comparing the yields of 10-year Treasury bonds, which have a yield of 4.75%, and 10-year corporate bonds, with a yield of 7.05%. The student is asked to consider the liquidity premium on the corporate bond, which is 0.6%. it's important to understand that corporate bonds typically offer a higher yield than Treasury bonds due to the higher risk of default; this is why the corporate bond in the question has a higher yield. Despite the higher risk, both Treasury and corporate bond interest rates are influenced by market conditions and tend to move in tandem.
Corporate bonds typically pay more than Treasury bonds, which in turn pay more than bank accounts. The higher yield on corporate bonds compensates investors for the extra risk assumed compared to the virtually risk-free Treasury bonds. Moody's ratings, as mentioned in the information provided, assess the creditworthiness of borrowers and categorize corporate bonds accordingly, with AAA being a high rating indicating relative safety in terms of the borrower's ability to repay.