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 6.80% per year for each of the next four years and 5.60% 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 0.60%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

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

1.) Berth Construction 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.)

10.60%

10.50%

11.10%

4.70%

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

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

The yield on a AAA-rated bond will be higher than the yield on a BB-rated bond.