From discussions with your broker, you have determined that the expected inflation premium is 1.35 percent next
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 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 five-year Treasury securities or five-year bonds issued by Anchor Corporation. The bonds have no special covenants. Your broker has determined the following information about economic activity and Anchor Corporation five-year bonds:
Default risk premium = 2.10% Liquidity risk premium = 1.75 Maturity risk premium = 0.75
Further, the maturity risk premium on Anchor bonds is 0.1875 percent per year starting in year 2. Anchor's default risk premium and liquidity risk premium do not change with bond maturity.a) What is the fair interest rate on five-year Treasury securities?b) What is the fair interest rate on Anchor Corporation five-year bonds?c) Plot the five-year yield curve for the Treasury securities.d) Plot the five-year yield curve for the Anchor Corporation bonds. e) Where would you invest your money?