The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year foreach of the next four years and 3% 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 0.55%. The following table shows the currentrelationship between bond ratings and default risk premiums (DRP):RatingDefault Risk PremiumU.S. TreasuryAAA0.60%AA.0.80%1.05%A.ВB1.45%Gauge Imports Inc. issues 12-year, AA-rated bonds. What is the yield on one of these bonds? Disregardcross-product terms; that is, if averaging is required, use the arithmetic average.5.25%8.58%8.03%7.48%Based on your understanding of the determinants of interest rates, if everything else remains the same, which of thefollowing will be true?A AAA-rated bond has less default risk than a BB-rated bond.The yield on a AAA-rated bond will be higher than the yield on a BB-rated bond

Computation of the yield:Hence, the yield is 8.58%.

Answered: The real risk-free rate (r*) is 2.8%…

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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