The real risk$-$free rate $($r$*)$ is $2\mathrm{.}8\%$ and is expected to remain constant. Inflation is expected to be $6\%$ per year for each of the next five years and $5\%$ thereafter.

The maturity risk premium $($MRP$)$ is determined from the formula: $0\mathrm{.}1($t $1)\%,$ where t is the security$$s maturity. The liquidity premium $($LP$)$ on all Smith and Carter Inc.$$s bonds is $0\mathrm{.}55\%.$ The following table shows the current relationship between bond ratings and default risk premiums $($DRP$)$:

Rating

Default Risk Premium

U$.$S$.$ Treasury $$

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

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

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

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

Smith and Carter Inc. issues twelve$-$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.

$9\mathrm{.}57\%$

$10\mathrm{.}12\%$

$5\mathrm{.}25\%$

$10\mathrm{.}67\%$

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

An AAA$-$rated bond has less default risk than a BB$-$rated bond.

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