Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

3. Calculating interest rates The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 6% per year

3. Calculating interest rates

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 6% per year for each of the next two years and 5% thereafter.

The maturity risk premium (MRP) is determined from the formula: 0.1(t 1)%, where t is the securitys maturity. The liquidity premium (LP) on all Gauge Imports Inc.s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

Rating

Default Risk Premium

U.S. Treasury
AAA 0.60%
AA 0.80%
A 1.05%
BBB 1.45%

Gauge Imports Inc. issues 10-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.

9.70%

5.05%

10.25%

9.35%

Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?

A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond.

In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity.

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Public Finance

Authors: Richard W. Tresch

2nd Edition

0126990514, 978-0126990515

More Books

Students also viewed these Finance questions

Question

List some problems associated with risk tolerance questionnaires.

Answered: 1 week ago