Assignment 06-Interest Rates The real risk-free rate ( *) is 2.8% and is expecte

Question

Assignment 06-Interest Rates The real risk-free rate ( *) is 2.8% and is expected to remain constant. Inflation is expected to be 8% per year for each of the next four years and 7% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(-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 current relationship between bond ratings and default risk premiums (DRP): Rating U.S. Treasury 0.60% 0.80% 1.05% 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. 12.4596 O 11.550 11.90% 5.05% ritondina of the determinants of interest rates, if everything else remains the same, which of the

Explanation / Answer

Nominal Yield of a bond = Real risk free rate + Inflation premium + Maturity risk premium + Default risk premium + Liquidity Premium

For the bond in question with 10 years to maturity,

Real risk free rate = 2.8%

Inflation premium (average of inflation over 10 year duration of bond) = [(8% * 4) + (7% * 6)]/10 = 7.4%

Maturity risk premium = 0.1 * (t-1)% = 0.1 * (10 - 1)% = 0.1 * 9% = 0.9%

Liquidity risk premium = 0.55%

Default risk premium = 0.80%

Hence, YTM on bond = 2.8% + 7.4% + 0.9% + 0.55% + 0.80% = 12.45% --> Option A

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