Introduction to Finance

b. 
What would be the infl ation premium on the Treasury bond if 
investors required a real rate of interest of 2.5 percent?
15. 
Challenge Problem 
Following are some selected interest rates.
Maturity 
or Term
Rate
Type of Security
1 year
4.0%
Corporate loan (high quality)
1 year 
5.0%
Corporate loan (low quality)
1 year
3.5%
Treasury bill
5 years
5.0%
Treasury note
5 years
6.5%
Corporate bond (high quality)
5 years
8.0%
Corporate bond (low quality)
10 years
10.5%
Corporate bond (low quality)
10 years 
8.5%
Corporate bond (high quality)
10 years
7.0%
Treasury bond
20 years
7.5%
Treasury bond
20 years
9.5%
Corporate bond (high quality)
20 years
12.0%
Corporate bond (low quality)
a. 
Plot a yield curve using interest rates for government default 
risk-free securities.
b. 
Plot a yield curve using corporate debt securities with low de-
fault risk (high quality) and a separate yield curve for low-quality 
corporate debt securities.
c. 
Measure the amount of default risk premiums, assuming con-
stant infl ation rate expectations and no maturity or liquidity risk 
premiums on any of the debt securities for both high-quality and 
low-quality corporate securities based on information from (a) 
and (b). Describe and discuss why diff erences might exist between 
high-quality and low-quality corporate debt securities.
d. 
Identify the average expected infl ation rate at each maturity level 
in (a) if the real rate is expected to average 2 percent per year and if 
there are no maturity risk premiums expected on Treasury securities.
e. 
Using information from (d), calculate the average annual ex-
pected infl ation rate over years 2 through 5. Also calculate the 
average annual expected infl ation rates for years 6 through 10 and 
for years 11 through 20.
f. 
Based on the information from (e), reestimate the maturity risk 
premiums for high-quality and low-quality corporate debt securi-
ties. Describe what seems to be occurring over time and between 
diff erences in default risks.

---