YIELD CURVES Suppose the inflation rate is expected to be 7% 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 fromzero 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 tomaturity, up to a limit of 1 0% on 5-year or longer-termT-bonds.

a. Calculate the interest rate on 1 , 2 , 3 , 4 , 5 , 10 , and 20-year Treasury securities and plot the yield curve.

b. 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 and plot 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.)

c. On the same graph, plot the approximate yield curve of a much riskier lower-rated company with a much higher risk of defaulting on its bonds.

AppendixLO1