Final answer:
It is false to assume that a corporate bond with a yield-to-maturity of 7% and an expected return of 5% in a perfect capital market is risk-free; the higher yield-to-maturity suggests an additional risk premium.
Step-by-step explanation:
The statement that a corporate bond must be risk-free if it has a yield-to-maturity of 7% and an expected return of 5% is false. In a perfect capital market, the expected return on a risk-free bond should equate to the risk-free rate, which in this scenario is 5%. If a corporate bond's expected return is also 5%, it implies it is considered risk-free. However, the yield-to-maturity being higher than the expected return and the risk-free rate indicates there is an additional risk premium embedded in the bond yield. This additional yield compensates investors for the risk they undertake by investing in the corporate bond over the risk-free bond.
Analysis of the bond market shows that corporate bonds typically offer higher interest rates than government bonds like Treasury bonds due to the higher risk associated with corporate borrowers. Despite operating in a perfect capital market, a bond can still carry risk if factors such as interest rate changes affect the market value of the bond. As interest rates rise, the price of existing bonds fall to make their yields competitive with newer bonds issued at higher rates. Therefore, a difference between yield-to-maturity and both the expected return and the risk-free rate suggests that the bond is not risk-free.