3. Calculating interest rates

The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next four years and 3%

thereafter.

The maturity risk premium (MRP) is determined from the formula: 0.1(t-1) %, where t is the security's maturity. The liquidity premium (LP) on all

National Transmissions Corp.'s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums

(DRP):

Rating

U.S. Treasury

AAA

AA

A

BBB

O 5.55%

National Transmissions Corp. issues 10-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.

O 8.05%

O 8.95%

Default Risk Premium

O 7.90%

0.60%

0.80%

1.05%

1.45%