Problem 6-18 (fundamentals of financial finance)

Yield Curves

Suppose the inflation rate is expected to be 6.45% next year, 4.6% the following year, and 3.05% thereafter. Assume that the real risk-free rate, r*, will remain at 2.3% 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-year Treasury securities. Round your answer to two decimal places.

b) Calculate the interest rate on 2-year Treasury securities. Round your answer to two decimal places.

c) Calculate the interest rate on 3-year Treasury securities. Round your answer to two decimal places.

d) Calculate the interest rate on 4-year Treasury securities. Round your answer to two decimal places.

e) Calculate the interest rate on 5-year Treasury securities. Round your answer to two decimal places.

f) Calculate the interest rate on 10-year Treasury securities. Round your answer to two decimal places.

g) Calculate the interest rate on 20-year Treasury securities. Round your answer to two decimal places.

h) Plot a yield curve based on these data. (which sketch is correct? a, b, c, d).

The correct sketch is: (a, b, c, d) ?

10 Interest Rate (%) 6 4 2 3 2 4 6 81012141618 Years to Maturity