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 two years and 5.60% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.10 x (t-1)%, where t is the security's maturity. The liquidity premium (LP) on all Harrington Horticulture Co.'s bonds is 0.60%. 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% Harrington Horticulture Co. issues seven-year, AA-rated bonds. What is the yield on one of these bonds? (Hint: Disregard cross-product terms; th if averaging is required, use an arithmetic average.) 10.74% 10.14% 4.80% 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 AAA-rated bond has less default risk than a BB-rated bond. The yield on a AAA-rated bond will be higher than the yield on a BB-rated bond