The real risk free rate is 2.8% and is expected to remain constant. Inflation is expected to be 8% per year for each of the next 5 years and 7% thereafter.

The maturity risk premium is determined from the formula : 0.1(t-1)%, where t is the security's maturity. The liquidity premium (LP) on all Pellegrini Sourthern Inc.'s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):

Rating                   DRP

U.S. Treasury         ----

AAA                         0.60%

AA                           0.80%

A                             1.05%

BBB                        1.45%

1a. Pellegrini Southern Inc. issues 9-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.

a. 12.21%

b. 13.01%

c. 11.96%

?d. 5.45%

1b. Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?

?a. Hiher inflation expectations increase the nominal interest rate demanded by investors.

?b. The yield on AAA-rated bond will be higher than the yield on a BB-rated bond.