Question

Suppose the inflation rate is expected to be 6% next year, 5% the following year, and 3% thereafter. Assume that the real risk-free rate, r*, will remain at 2% 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.

Select the correct yield curve based on these data.

The correct sketch is -Select-ABCDItem 8 .

  1. Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20-year Treasury securities. Round your answers to two decimal places.Treasury securitiesInterest rate1-year  %2-year  %3-year  %4-year  %5-year  %10-year  %20-year  %

  2. 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-rise above fall below be the same as item 9 the yield curve for the Treasury securities.

  3. 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-above below the same item 11 the yield curve for the AAA-rated corporate bonds.

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Homework Answers

Answer #1

1.
1 year=2%+6%+0.2%=8.20000%

2 year=2%+(6%+5%)/2+0.2%*2=7.90000%

3 year=2%+(6%+5%+3%)/3+0.2%*3=7.26667%

4 year=2%+(6%+5%+3%*2)/4+0.2%*4=7.05000%

5 year=2%+(6%+5%+3%*3)/5+0.2%*5=7.00000%

10 year=2%+(6%+5%+3%*8)/10+0.2%*5=6.50000%

20 year=2%+(6%+5%+3%*18)/20+0.2%*5=6.25000%

2.
The yield risk curve for the AAA-rated corporate bonds will rise above the yield curve for the Treasury securities.

3.
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.

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