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? INPUT DATA Real risk-free rate 3% Expected inflation of Expected inflation of Expected inflation of 5% 6% 8% for the next year. for the following year. thereafter. MRP of 0.10% for each year after 1 1 IP: + Maturity (in years) 1 year Treasury yield = 1-year Treasury yield 1-year Treasury yield MRP 10 IP1 10 2 Maturity (in years) 3 10-year Treasury yield = 4 10-year Treasury yield 5 10-year Treasury yield = MRP 10 PARTH Suppose that you observe the following term structure for Treasury securities: Maturity 1 year 2 years 3 years 4 years 5 years Yield 6.0% 6.2% 6.4% 6.5% 6.5% Assume that the pure expectations theory of the term structure is correct. (This implies that you can use the yield curve provided to "back out" the market's expectations about future interest rates.) What does the market expect will be the interest rate on 1-year securities one year from now? (1 + 1) X x 111 Assume that the pure expectations theory of the term structure is correct. (This implies that you can use the yield curve provided to "back out" the market's expectations about future interest rates.) Calculate the following future interest rates. 1 year Maturity Maturity 1 2 years 2 3 4 years 4 5 years 5 Yield 5.02% 5.31% 5.48% 5.65% 5.73% 3 years (1+z)? X (1 + 211) 211 (1+14)" (1+13) x x (1 + 371) 311 (1+5) x x (1 + 411) 411