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 0 percent 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.

a. Calculate the interest rate on one-, two-, three-, four-, five-, 10-, and 20-year

Treasury securities and plot the yield curve.

b. 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 bonds versus its short-term bonds.)

c. Now plot the approximate yield curve of Long Island Lighting Company, a

risky nuclear utility