FINANCE
6-18 Yield Curves: 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 .02% for 1 tear securities. Furthermore, maturity risk premiums increase .02% for each year to maturity, up to a limit of 1.0% on year or longer T bonds.
a. Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20- 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 company’s yield curve would look like on the same graph with the Treasury bond yield curve. (Hint, think about the default risk premiums on its long-term versus its short term bonds).
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.
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