3. Calculating interest rates

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 8% per year for each of the next five years and 7% 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 BTR Warehousings bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

Default Risk Premium Rating U.S. Treasury AAA 0.60% AA 0.80% A 1.05% BBB 1.45% BTR Warehousing issues fourteen-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. 11.51% O 12.81% O 5.45% O 12.26% Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? O A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond. O An AAA-rated bond has less default risk than a BB-rated bond