1 Interest Rate Determination and Yield Curves 3 b. Finding the yield for each of the two investments 4 Real risk-free rate 3% 5 Expected inflation 3% for the next 6 Expected inflation 2 years 7 Expected inflation thereafter 4 years 5% 8 Maturity risk premium = 9 Liquidity premium 0.01%(t1) 0.2% 10 Maturity of treasury bond 12 years 11 Maturity of corporate bond 7 years 12 Corporate bond rating A 13 14 12-year Treasury Bond Formulas 15 Real risk-free rate IIN/A 16 Inflation premium HN/A 17 Matunty risk premium \#N/A 18 12-year Treasury yield \#N/A 19 2021222324RatingAAAAAADRP+LP0.10%0.48%0.84% 25 -year Corporate Bond 26 Real nisk-tree rate 27 inflation premium \#N/A 28 Matunty risk premium #N/A #N/A c. Constructing a graph of the yield curve d. Calculating yields and then constructing a new yield curve graph that shows both the Treasury and the corporate bonds 1020300.00%MNA0.00%#NA0.00%FNA 1. Calculating the rates using geometric averages Formulas (1) Calculating the 1 -year rate, 1 year from now (2) Calculating the 5 -year rate, 5 years from now (3) Calculating the 10 -year rate, 10 years from now 100 (4) Calculating the 10 -year rate, 20 years from now a. What effect would each of the following events likely have on the level of nominal interest rates? 1. Households dramatically increase their savings rate. This action will the supply of money; therefore, interest rates will 2. Corporations decrease their demand for funds following a decrease in investment opportunities. This action will cause interest rates to 3. The government runs a smaller-than-expected budget deficit. The smaller the federal deficit, other things held constant, the the level of interest rates. 4. There is an increase in expected inflation. This expectation will cause interest rates to b. Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years, 4% for the following 4 years, and 5% thereafter. The maturity risk premium is estimated by this formula: MRP =0.01(t1)%. The liquidity premium (LP) for the corporate bond is estimated to be 0.2%. You may determine the default risk premium (DRP), given the company's bond rating, from the following table. Remember to subtract the bond's LP from the corporate spread given in the table to arrive at the bond's DRP. Corporate Bond Yield What vield would you predict for each of these two investments? Round your answers to three decimal places. 12-year Treasury vield: 7-year Corporate vield: c. Given the following Treasury bond yield information, construct a graph of the yield curve. Choose the correct graph. The correct graph is Watid Cue s D. Yield Cune ased on the information about the corporate bond provided in part b, calculate yields and then construct a new yield curve graph hat shows both the Treasury and the corporate bonds. Round your answers to two decimal places. Choose the correct graph. The correct graph is A. B. Ireasury and Corporate Yield Cunves Which part of the yield curve (the left side or right side) is likely to be most volatile over time? Short-term rates are volatile than longer-term rates; therefore, the ich part of the yield curve (the left side or right side) is likely to be most volatile over time? iort-term rates are time. volatile than longer-term rates; therefore, the side of the yield curve would be most volatile Ising the Treasury yield information in part c, calculate the following rates using geometric averages (round your answers to three decimal places): 1. The 1 -year rate, 1 year from now % 2. The 5 -year rate, 5 years from now % 3. The 10 -year rate, 10 years from now 4. The 10 -year rate, 20 years from now