9. Calculating interest rates

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next two years and 3% thereafter.

The maturity risk premium (MRP) is determined from the formula: 0.1(t 1)%, where t is the securitys maturity. The liquidity premium (LP) on all Smith and Carter Inc.s bonds is 0.55%. 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%

Smith and Carter Inc. issues 10-year, AA-rated bonds. What is the yield on one of these bonds? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average.

8.25%

7.35%

5.05%

7.70%

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

In theory, the yield on a bond with a longer maturity will be higher than the yield on a bond with a shorter maturity.

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