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5. U.S. Treasury bonds are assumed by most investors to be free of default risk because the federal government has always met its promised scheduled
5. U.S. Treasury bonds are assumed by most investors to be free of default risk because the federal government has always met its promised scheduled payments on time and it is presumed that the federal government could always raise future taxes to meet its future obligations. The risk premium on other bonds with default risk is the difference between the yield-to-maturity on each of those bonds and the yield-to-maturity on a U.S. Treasury bond with the same maturity. There is, however, another risk premium that is associated with the maturity of a bond, and most U.S. Treasury bonds are not free from this risk. (a) First, explain what is meant by interest-rate risk, how does it vary with the maturity of a bond, and how does this risk differ from default risk. Second, how does interest-rate risk act to bias the sequence of implied one-year forward rates as estimators of market expectations of future short-term interest rates? (b) What are the implications discerned from the shape of the yield curve on forecasting market expectations of the sequence of future one-year interest rates? In your answer, consider the case of a flat yield curve
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