$7.$ Calculating interest rates

The real risk$-$free rate $($r$*)$ is $2\mathrm{.}80\%$ and is expected to remain constant into the future. Inflation is expected to be $4\mathrm{.}05\%$ per year for each of the next four years and $2\mathrm{.}85\%$ thereafter.

The maturity risk premium $($MRP$)$ is determined from the formula: $0\mathrm{.}10$ x $($t $1)\%,$ where t is the security$$s maturity. The liquidity premium $($LP$)$ on all Gauge Imports Inc.$$s bonds is $0\mathrm{.}60\%.$ The following table shows the current relationship between bond ratings and default risk premiums $($DRP$)$:

Rating

Default Risk Premium

U$.$S$.$ Treasury $$

AAA $0\mathrm{.}60\%$

AA $0\mathrm{.}80\%$

A $1\mathrm{.}05\%$

BBB $1\mathrm{.}45\%$

Gauge Imports Inc. issues six$-$year, AA$-$rated bonds. What is the yield on one of these bonds? $($Hint: Disregard cross$-$product terms; that is$,$ if averaging is required, use an arithmetic average.$)$

$4\mathrm{.}70\%$

$8\mathrm{.}35\%$

$7\mathrm{.}75\%$

$7\mathrm{.}85\%$

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

The yield on U$.$S$.$ Treasury securities always remains static.

Higher inflation expectations increase the nominal interest rate demanded by investors.