A$)$

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 $1\%$ and that maturity risk premiums on Treasury securities rise from zero on very short$-$term bonds $($those that mature in a few days$)$ to $0\mathrm{.}2\%$ for $1-$year securities$.$ Furthermore, maturity risk premiums increase $0\mathrm{.}2\%$ for each year to maturity, up to a limit of $1\mathrm{.}0\%$ on $5-$year or longer$-$term T$-$bonds.

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

Treasury securities Interest rate

$1-$year

$\%$

$2-$year

$\%$

$3-$year

$\%$

$4-$year

$\%$

$5-$year

$\%$

$10-$year

$\%$

$20-$year

$\%$

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$-$

the yield curve for the Treasury securities$.$

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$-$

the yield curve for the Treasury securities and

$-$Select$-$

the yield curve for the AAA$-$rated corporate bonds.

B$)$

In late $1980,$ the U$.$S$.$ Commerce Department released new data showing inflation was $15\%.$ At the time, the prime rate of interest was $21\%,$ a record high. However, many investors expected the new Reagan administration to be more effective in controlling inflation than the Carter administration had been. Moreover, many observers believed that the extremely high interest rates and generally tight credit, which resulted from the Federal Reserve System's attempts to curb the inflation rate, would lead to a recession, which, in turn, would lead to a decline in inflation and interest rates. Assume that at the beginning of $1981,$ the expected inflation rate for $1981$ was $13\%$; for $1982,10\%$; for $1983,6\%$; and for $1984$ and thereafter, $5\%.$

What was the average expected inflation rate over the $5-$year period $1981-1985?($Use the arithmetic average.$)$ Round your answer to two decimal places.

$\%$

Over the $5-$year period, what average nominal interest rate would be expected to produce a $2\%$ real risk$-$free return on $5-$year Treasury securities$?$ Assume MRP $=0.$ Round your answer to two decimal places.

$\%$

Assuming a real risk$-$free rate of $2\%$ and a maturity risk premium that equals $0\mathrm{.}1\backslash$times $($t$)\%,$ where t is the number of years to maturity, estimate the interest rate in January $1981$ on bonds that mature in $1,2,5,10$ and $20$ years. Round your answers to two decimal places.

Year rt

$1$

$\%$

$2$

$\%$

$5$

$\%$

$10$

$\%$

$20$

$\%$

$$