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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.l(t - 1)%, where t is the security's maturity. The liquidity premium on all Pettigrew Power Co.'s bonds is 0.75%. The following table shows the current relationship between bond ratings and default risk premiums:
Rating Default Risk PremiumU.S. Treasury -AAA 0.60%AA 0.80%A 1.05%BBB 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.
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