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 security's 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):

RatingDefault Risk PremiumU.S. TreasuryAAA0.60%AA0.80%A1.05%BBB1.45%

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.

A. 7.70%

B. 7.35%

C. 5.05%

D. 8.25%

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

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

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