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 3.20% per year for each of the next two years and 2.00% 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 Global Satellite Corp.s bonds is 0.50%. 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%

Global Satellite Corp. issues nine-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. 6.67%

B. 7.17%

C. 6.37%

D. 4.90%

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- A BBB-rated bond has a lower default risk premium as compared to a AAA-rated bond.