Suppose the inflation rate is expected to be 7 next

Suppose the inflation rate is expected to be 7% next year, 5% the following year, and 3%
thereafter. Assume that the real risk-free rate, r*, will remain at 2% and that maturity risk
premiums on Treasury securities rise from zero on very short-term bonds (those that mature in
a few days) to 0.2% for 1-year securities. Furthermore, maturity risk premiums increase 0.2%
for each year to maturity, up to a limit of 1.0% on 5-year or longer-term T-bonds.a. Calculate the
interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20-year Treasury securities and plot the yield curve.b.
Suppose a AAA-rated company (which is the highest bond rating a firm can have) had bonds
with the same maturities as the Treasury bonds. Estimate and plot what you believe a AAA-
rated company’s yield curve would look like on the same graph with the Treasury bond yield
curve. c. On the same graph, plot the approximate yield curve of a much riskier lower-rated
company with a much higher risk of defaulting on its bonds.View Solution:
Suppose the inflation rate is expected to be 7 next
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