The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 7% per year for each of the next two years and 6% 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 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

Rating	Default Risk Premium
U.S. Treasury
AAA	0.60%
AA	0.80%
A	1.05%
BBB	1.45%

Smith and Carter Inc. issues nine-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.

10.62%

10.37%

11.17%

4.95%

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

A 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 a AAA-rated bond.