Reference no: EM133119083

As an investor, you 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. Assuming that the real risk-free rate, k*, 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 a level of 0.2% point for 1-year securities. Furthermore, maturity risk premiums increase 0.2% point for each year to maturity, up to a limit of 1.0% point of 5-year or longer-term T-bonds. From the information, you are required to answer the following questions.

a. Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10- and 20-year treasury securities, and plot the yield curve.

b. Using your answer in part (a), draw the yield curve.

c. Explain the general economic conditions that could be expected to produce the yield curve at (b).

d. What would you do if you are the lender? Are going to lend more? Or less? Explain your answer.