Suppose you and most other investors expect the rate of inflation to be 7 percent next year, to fall to 5 percent during the following year, and then to remain at a rate of 3 percent thereafter. Assume that the real risk-free rate, r*, is 2 percent and that maturity risk premiums on Treasury securities rise from zero on very short-term bonds (those that mature in a few days) by 0.2 percentage points for each year to maturity, up to a limit of 1.0 percentage point on five-year or longer-term T-bonds. IBM warrants a DRP of 0.4% and a liquidity premium of 0%.

1. Calculate the interest rate on one-, two-, three-, four-, five-, 10-, and 20-year Treasury securities and plot the yield curve.
2. Now suppose IBM, a highly rated company, had bonds with the same maturities as the Treasury bonds. As an approximation, plot a yield curve for IBM on the same graph with the Treasury bond yield curve. (Hint: Think about the default risk premium on IBMs long-term versus its short-term bonds.)