Question

Suppose the inflation rate is expected to be 6.3% next year, 4% the following year, and 3.5% thereafter. Assume that the real risk-free rate, r*, will remain at 1.55% and that maturity risk premiums on Treasury securities rise from zero on very short-term bonds (those that mature in a few days) to 0.2% for 1-year securities. Furthermore, maturity risk premiums increase 0.2% for each year to maturity, up to a limit of 1.0% on 5-year or longer-term T-bonds.

Calculate the interest rate on 2-year Treasury securities. Round your answer to two decimal places.

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Calculate the interest rate on 3-year Treasury securities. Round your answer to two decimal places.

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Calculate the interest rate on 4-year Treasury securities. Round your answer to two decimal places.

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Calculate the interest rate on 5-year Treasury securities. Round your answer to two decimal places.

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Calculate the interest rate on 10-year Treasury securities. Round your answer to two decimal places.

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Calculate the interest rate on 20-year Treasury securities. Round your answer to two decimal places.

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Select the correct yield curve based on these data.

1. Calculate the interest rate on 1-year Treasury securities. Round your answer to two decimal places.
   
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2. The correct sketch is -Select-ABCDItem 8 .
   
   • Suppose a AAA-rated company (which is the highest bond rating a firm can have) had bonds with the same maturities as the Treasury bonds. Estimate what you believe a AAA-rated company's yield curve would look like on the same graph with the Treasury bond yield curve. (Hint: Think about the default risk premium on its long-term versus its short-term bonds.)
     
   • The yield risk curve for the AAA-rated corporate bonds will -Select- 9 the yield curve for the Treasury securities.
     
     • What will be the approximate yield curve of a much riskier lower-rated company with a much higher risk of defaulting on its bonds?
       
     • The yield risk curve of a much riskier lower-rated company will be -Select-above below the same as item 10 the yield curve for the Treasury securities and -Select- 11 the yield curve for the AAA-rated corporate bonds.
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Answer 1

1 year
=1.5%+6.3%+0.2%=8.00%

2 year
=1.5%+(6.3%+4%)/2+0.2%*2=7.05%

3 year
=1.5%+(6.3%+4%+3.5%)/3+0.2%*3=6.70%

4 year
=1.5%+(6.3%+4%+3.5%*2)/4+0.2%*4=6.625%

5 year
=1.5%+(6.3%+4%+3.5%*3)/5+0.2%*5=6.66%

10 year
=1.5%+(6.3%+4%+3.5%*8)/10+1%=6.33%

20 year
=1.5%+(6.3%+4%+3.5%*18)/20+1%=6.165%

The yield risk curve for the AAA-rated corporate bonds will be above the yield curve for the Treasury securities.

The yield risk curve of a much riskier lower-rated company will be above the yield curve for the Treasury securities and above the yield curve for the AAA-rated corporate bonds.