Question 3

a) Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4%; and inflation is expected to be 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0.02(t – 1)%. The liquidity premium (LP) for the corporate bond is estimated to be 0.3%. You may determine the default risk premium (DRP), given the company’s bond rating, from the table below. Remember to subtract the bond’s LP from the corporate spread given in the table to arrive at the bond’s DRP. What yield would you predict for each of these two investments? 

b) Given the following Treasury bond yield information, construct a graph of the yield curve.

c) Based on the information about the corporate bond provided in Part a, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds. Comment which part of the yield curve (the left side or right side) is likely to be most volatile over time?