Need help with this problem (practice exercise):
Suppose you and most other investors expect the inflation rate to be 7% next year, to fall to 5% during the following year, and then to remain at a rate of 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 securities (those that mature in a few days) to a level of 0.2 percentage point for 1 year securities. Furthermore, maturity risk premiums increase 0.2 percentage point for each year to maturity, up to a limit of 1.0 percentage point on 5-year or longer-term T-notes and T-bonds.
a) Calcualte the interest rate on 1-, 2-, 3-, 4-, 5-, 10-, and 20-year Treasury securities, and plot the yield curve.
b) Now suppose ExxonMobil, an AAA-rated company, had bonds with the same maturities as the Treasury bonds. As an approximation, plot an ExxonMobil yield curve on the same graph with the Treasury bond yield curve. (Hint: Think about the default risk premium on ExxonMobil's long-term versus its short-term bonds.)
c) Now plot the approximate yield curve of Long Island Lighting Company, a risky nuclear utility.
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The solution explains how plot and interpret the yield curve in a one and a half paged Word document attached. Tables and graphs included.