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 8% per year for each of the next five years and 790 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 (LP) on all Gauge Imports Inc.'s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Rating Default Risk Premium U.S. Treasury 0.60% 0.80% 1.05% 1.45% Gauge Imports Inc. issues 11-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average 0 5.65% O 12.05% 13.10% O 12.10%

Explanation / Answer

yield on the bond

=real risk free rate+average inflation premium+MRP+LP+default risk premium

=2.8%+((8%*5+7%*6)/11)+(0.1*(11-1)%)+1.05%+0.80%

=13.10%

the above is answer..

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