What is the lower and upper limit of Investment 3
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As from investment 1 and 2 they have same maturity but investment 2 has low liquidity.
So, liquidity premium is 0.5
And from investment 4 and 5 we can see investment 8 has liquidity+default risk.so,as we know liquidity is 0.5 so default risk is 2.
Now, for 3 it has low liquidity so lower limit will be 2.5.
For upper limit we should look at investment 4 it has low liquidity and low default risk,but investment 3 has liquidity risk so upper limit would be 4+0.5=4.5
I hope this helps you!
Thank you
Comparing investments 1 and 2:
All the factors are same except liquidity. Investment2 is less liquid than investment1. So we ask for more return from investment2 for the liquidity risk. So, 2.5-2 = 0.5
This 0.5% is liquidity risk premium.
Comparing investments 4 and 5:
Default risk premium = 6.5 – (4 + 0.5) = 2%
Comparing investments 2 and 3:
Investment3 has longer maturity period than investment2. So investment3 includes maturity risk premium. So r3 = 2.5 + maturity risk premium. Therefore 2.5 < r3.
Comparing investments 3 and 4:
Therefore r3 = r3 = 2.5 + 0.5 + maturity risk premium = 3 + maturity risk premium
Answer. 2.5 < r3 < 4.5