The problem requires you to use File C05 on the computer problem spreadsheet.
a. Assume today is January 2, and the expected inflation rates for the next five years are as follows:
Year Inflation Rate
1 ............. 8.0%
2 ............. 6.0
3 ............. 4.0
4 ............. 3.0
5 ............. 5.0
In Year 6 and thereafter, inflation is expected to be 3 percent. The maturity risk premium (MRP) is 0.1 percent per year to maturity for bonds with maturities greater than six months, with a maximum MRP equal to 2 percent. The real risk-free rate of return is currently 2.5 percent, and it is expected to remain at this level long into the future. Compute the interest rates on Treasury securities with maturities equal to one year, two years, three years, four years, five years, 10 years, 20 years, and 30 years.
b. Discuss the yield curve that is constructed from the results in part (a).
c. Rework part (a) assuming one year has passed—that is, today is January 1 of Year 2. All the other information given in part (a) is the same. Rework part (a) again assuming two, three, four, and five years have passed.
d. Assume that all the information given previously is the same and the default risk premium for corporate bonds rated AAA is 1.5 percent, whereas it is 4 percent for corporate bonds rated B. Compute the interest rates on AAA- and B-rated corporate bonds with maturities equal to one year, two years, three years, four years, five years, 10 years, 20 years, and 30 years.