The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflati

Question

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 5% per year for each of the next three years and 4% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(t - 1)%, where t is the security's maturity. The liquidity premium on all Pettigrew Power Co.'s bonds is 0.95%. The following table shows the current relationship between bond ratings and default risk premiums: Rating Default Risk Premium U.S. Treasury - AAA 0.60% AA 0.80% A 1.05% BB8 1.45% What is the yield on a seven-year, AA-rated bond issued by Pettigrew? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. 9.63% 9 68% 9.33% 9.58% 9.28%

Explanation / Answer

r = r* + IP + DRP + LP + MRP Where r = required return on a security ??? r* = real risk-free rate of interest =2.8% IP = inflation premium = 5% for 3 yrs & 4% thereafter DRP = default risk premium = 0.8% as AA security LP = liquidity premium = 0.95% MRP = maturity risk premium =0.1*(t-1)%= 0.1*(7-1)%= 0.6% IP = (5%*3+4%*4)/7 = 4.43% Putting values r =2.8%+4.43%+0.8%+0.95%+0.6% = 9.58%.................Ans

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