The real risk-free rate (r*) is 2.80% and is expected to remain constant into the future. Inflation is expected to be 7.50% per year for each of the next four years and 6.30% thereafter.

The maturity risk premium (MRP) is determined from the formula: 0.10 x (t 1)%, where t is the securitys maturity. The liquidity premium (LP) on all Sacramone Products Co.s bonds is 0.50%. 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%

Sacramone Products Co. issues fourteen-year, AA-rated bonds. What is the yield on one of these bonds? (Hint: Disregard cross-product terms; that is, if averaging is required, use an arithmetic average.)

10.74%

12.04%

5.40%

11.54%

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 a AAA-rated bond.

The yield on a AAA-rated bond will be lower than the yield on a AA-rated bond.