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 Dare Satellite Corp.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%

Dare Satellite Corp. 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.

5.25%

10.87%

11.42%

10.32%

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

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

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