The real risk-free rate (r*) is 2.8% 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: 0.1(t 1)%, where t is the securitys maturity. The liquidity premium (LP) on all Smith and Carter Inc.s bonds is 1.05%. 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 fourteen-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.

5.95%

10.26%

11.31%

10.01%

Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true? A BBB-rated bond has a lower default risk premium as compared to an AAA-rated bond. An AAA-rated bond has less default risk than a BB-rated bond.