Transcribed Image Text
Assume that the real risk-free rate of return, r*, is 1%, and itwill remain at that level far into the future. Also assume thatmaturity risk premium on Treasury bonds increase from zero forbonds that mature in one year or less to a maximum of 2%, and MRPincreases by 0.2% for each year to maturity that is greater thanone year – that is, MRP equals 0.2% for two-year bond, 0.4% for athree-year bond, and so forth. Following are the expected inflationrates for the next five years:YearInflation Rate20181%20191.5%20202%20212.5%Compute the interest rate for 1, 2, 3, and 4-year bond.If inflation is expected to equal 3% every year after 2021, whatshould the interest rate be for 5- through 20-year bond?Draw a graph of the yield curve.