Question

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



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  • CreatedNovember 24, 2014
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