1) a. Suppose you are considering two possible investment opportunities, a 12-year Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4%. Inflation is expected to be 2% for the next two years, 3% for the following four years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0.1% ( t-1) %. The liquidity premium for the corporate bond is estimated to be 0.7%. Finally, you may determine the default risk premium, given the company’s bond rating, from the default risk premium table in the text. What yield would you predict for each of these two investments?
b. Given the following Treasury bond yield information from the September 28, 2001, Federal Reserve Statistical Release, construct a graph of the yield curve as of that date.
c. Based on the information about the corporate bond that was given in Part a, calculate yields and then construct a new graph that shows both the Treasury and the corporate bonds.
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Answers questions on interest rates and yield curve.