The nominal interest rate on a debt security, r, is composed of a real risk-free rate of interest,r*, plus several premiums that reflect inflation, the riskiness of the security and the security'smarketability. This relationship can be expressed as follows:

r = r* + IP + DRP + LP + MRP

Required:

1. Describe and explain the two fundamental factors affecting r*, the real risk-free rate of interest. (5 marks)
2. How would the yield curve facing a BB-rated company compare with the yield curve for the U.S. Treasury securities? Illustrate your answer with respect to the above relationship. (5 marks)
3. If the Federal Reserve expands the money supply by buying $50 billion of short-term U.S. Treasury securities from the public, other things held constant, what will be the immediate effects to short-term Treasury security prices and interest rates? How about the long-term effects on the level of the yield curve for the U. S. Treasury securities? (5 marks)