The real risk$-$free rate $($r$*)$ is $2\mathrm{.}80\%$ and is expected to remain constant into the future. Inflation is expected to be $6\mathrm{.}80\%$ per year for each of the next four years and $5\mathrm{.}60\%$ thereafter.

The maturity risk premium $($MRP$)$ is determined from the formula: $0\mathrm{.}10$ x $($t $1)\%,$ where t is the security$$s maturity. The liquidity premium $($LP$)$ on all Harrington Horticulture Co$.$s bonds is $1\mathrm{.}20\%.$ The following table shows the current relationship between bond ratings and default risk premiums $($DRP$)$:

Rating

Default Risk Premium

U$.$S$.$ Treasury $$

AAA $0\mathrm{.}60\%$

AA $0\mathrm{.}80\%$

A $1\mathrm{.}05\%$

BBB $1\mathrm{.}45\%$

Harrington Horticulture Co$.$ issues ten$-$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.$)$

$11\mathrm{.}78\%$

$10\mathrm{.}58\%$

$5\mathrm{.}70\%$

$10\mathrm{.}88\%$

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

The yield on a AAA$-$rated bond will be lower than the yield on a AA$-$rated bond.

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