1. The real risk-free rate (r*) is 2.80% and is expected to remain constant into the future. Inflation is expected to be 6.80% per year for each of the next two years and 5.60% thereafter.

The maturity risk premium (MRP) is determined from the formula: 0.10 x (t – 1)%, where t is the security’s maturity. The liquidity premium (LP) on all National Transmissions Corp.’s bonds is 1.20%. 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%
National Transmissions Corp. issues thirteen-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.)

10.58%

11.78%

6.00%

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

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

B) The yield on a AAA-rated bond will be higher than the yield on a BB-rated bond.