The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 5% per year for each of the next two years and 4% 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 Gauge Imports 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%

Gauge Imports Inc. issues 14-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.

8.79%

9.04%

10.09%

5.95%

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.

Higher inflation expectations increase the nominal interest rate demanded by investors.