Question: 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 0.2% for 1 -year securities. Furthermore, maturity risk premiums increase 0.2% for each year to maturity, up to a limit of 1.0% on 5 -year or longer-term T-bonds.

1. Calculate the interest rate on 1,, 2-, 32, 4-, 5-, 10-, and 20-year Treasury securities and plot the yield curve.
2. 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-rated company's yield curve would look like on the same graph with the Treasury bond yield curve. (Hint: Think about the default risk premium on its long-term versus its short-term bonds.)
3. Or 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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