3. Suppose the inflation rate is expected to be 2%/year next year, 1%/year in the following 3 years, and 0.5%/year thereafter. Assume that the real risk-free interest rate will remain at 1.5%. Maturity risk premium on a debt security is determined by 0.05% (t 1) where t is the number of years to maturity of the debt security.

   a) Calculate the interest rate on 1, 5, and 10 year Treasury securities.

   b) The following table provides quoted interest rates on various bonds with similar maturity. Using the data reported on the table, compute the default risk premium of A corporate bond by taking the difference between the quoted interest rate on A corporate bond and the quoted interest rate on the US Treasury.

   c) Assume liquidity premium stays at 0.7% for the A corporate bond, regardless of its years to maturity. Along with default risk premium (found in part b) and information about expected inflation and maturity risk premium, calculate the interest rate on 1, 5, and 10 year A bond.

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	Interest rate
U.S. Treasury bond	2.53%
AAA corporate	2.75%
AA corporate	2.89%
A corporate	3.06%

d) Plot the yield curve of A bond together with the yield curve of Treasury securities.

e) Describe the yield curve for U.S. Treasury securities.

f) How does the yield curve of the A rated bond compare with the yield curve for U.S. Treasury securities?

g) How does the yield curve of a C rated bond compare with the yield curves for U.S. Treasury and A corporate bond? Explain.

4. Suppose the inflation rate is expected to be 2%/year next year, 1%/year in the following 3 years, and 0.5%/year thereafter. Assume that the real risk-free interest rate will remain at 1.5%. Maturity risk premium on a debt security is determined by 0.05% (t 1) where t is the number of years to maturity of the debt security.

a) Calculate the interest rate on 1, 5, and 10 year Treasury securities.

b) The following table provides quoted interest rates on various bonds with similar maturity. Using the data reported on the table, compute the default risk premium of A corporate bond by taking the difference between the quoted interest rate on A corporate bond and the quoted interest rate on the US Treasury.

Interest Rate

U.S Treasury Bond. 2.53%

AAA Corporate. 2.75%

AA Corporate. 2.89%

A Corporate. 3.06%

c) Assume liquidity premium stays at 0.7% for the A corporate bond, regardless of its years to maturity. Along with default risk premium (found in part b) and information about expected inflation and maturity risk premium, calculate the interest rate on 1, 5, and 10 year A bond.

d) Plot the yield curve of A bond together with the yield curve of Treasury securities.

e) Describe the yield curve for U.S. Treasury securities.

f) How does the yield curve of the A rated bond compare with the yield curve for U.S. Treasury securities?

g) How does the yield curve of a C rated bond compare with the yield curves for U.S. Treasury and A corporate bond? Explain.