1.Suppose the inflation rate is expected to be 6% next year, 4% the following year, and 2% thereafter. Assume that the real risk-free rate, r*. will remain at 1% 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.

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

b.Suppose AAA-rated company (which is the highest bond rating a firm can have) had bonds with the same maturities as the Treasury bonds. As an approximation, 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 low-rated company with a much higher risk of defaulting on its bonds.