Maria Juarez is a professional tennis player, and your firm manages her money. She has asked you to
give her information about what determines the level of various interest rates. Your boss has prepared
some questions for you to consider.
a) Suppose most investors expect the inflation rate to be 5% next year, 6% the following
year, and 8% thereafter. The real risk-free rate is 3%. The maturity risk premium is zero
for bonds that mature in 1 year or less and 0.1% for 2-year bonds; then the MRP increases
by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest rate
on 1-, 10-, and 20-year Treasury bonds? Draw a yield curve with these data. What factors
can explain why this constructed yield curve is upward-sloping?
b) At any given time, how would the yield curve facing a AAA-rated company compare
with the yield curve for U.S. Treasury securities? At any given time, how would the yield
curve facing a BB-rated company compare with the yield curve for U.S. Treasury
securities? Draw a graph to illustrate your answer.
c) What is the pure expectations theory? What does the pure expectations theory imply
about the term structure of interest rates?
d) Describe how macroeconomic factors affect the level of interest rates.