7. Calculating interest rates

The real risk-free rate (r*) is 2.80% and is expected to remain constant into the future. Inflation is expected to be 4.05% per year for each of the next two years and 2.85% thereafter.

The maturity risk premium (MRP) is determined from the formula: 0.10 x (t 1)%, where t is the securitys maturity. The liquidity premium (LP) on all Berth Construction Inc.s bonds is 1.10%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

Rating	Default Risk Premium
U.S. Treasury
AAA	0.60%
AA	0.80%
A	1.05%
BBB	1.45%

Berth Construction Inc. issues seven-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.)

a. 7.89%

b. 8.49%

c. 7.39%

d .5.30%

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

1. A AAA-rated bond has less default risk than a BB-rated bond.

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