Maria Juarez is a professional tennis player, and your firm manages her money. She has asked you to give her information about what determines the level of various interest rates. Your boss has prepared some questions for you to consider.

a. What is the real risk-free rate of interest (r* rates measured? ) and the nominal risk-free rate (rRF )? How are these two rates measured?

b. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included in determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed.

c. Suppose most investors expect the inflation rate to be 5% next year, 6% the following year, and 8% thereafter. The real risk-free rate is 3%. The maturity risk premium is zero for bonds that mature in 1 year or less and 0.1% for 2-year bonds; then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest rate on 1-, 10-, and 20-year Treasury bonds? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping?