Question: From discussions with your broker, you have determined that the expected inflation premium is 1.35 percent next year, 1.50 percent in year 2, 1.75 percent

From discussions with your broker, you have determined that the expected inflation premium is 1.35 percent next year, 1.50 percent in year 2, 1.75 percent in year 3, and 2.00 percent in year 4 and beyond. Further, you expect that real risk free rates will be 3.20 percent next year, 3.30 percent in year 2, 3.75 percent in year 3, and 3.80 percent in year 4 and beyond. You are considering an investment in either 5-year Treasury securities or 5-year bonds issued by PeeWee Corporation. The bonds have no special covenants. Your broker has determined the following information about economic activity and PeeWee Corporation 5-year bonds:

Default risk premium = 2.10%

Liquidity risk premium = 1.75%

Maturity risk premium = 0.75%

Further, the maturity risk premium on PeeWee bonds is 0.1875 percent per year starting in year 2. PeeWee’s default risk premium and liquidity risk premium do not change with bond maturity.

a. What is the fair interest rate on 5-year Treasury securities?

b. What is the fair interest rate on PeeWee Corporation 5-year bonds?

c. Plot the 5-year yield curve for the Treasury securities.

d. Plot the 5-year yield curve for the PeeWee Corporation bonds.

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