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06 Chapter model

8/10/2016 13:11

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2/14/2006

Chapter 6. Interest Rates

THE DETERMINANTS OF INTEREST RATES (Section 6.3)
Interest rates can easily be observed. All it requires is reading the newspaper, watching television,
or surfing the internet. However, it is not so easy to see the factors that determine market interest
rates, and the extent to which they shape interest rates. Naturally, the determination of interest rates
is a macroeconomic question that has numerous contributing factors. However, in an effort to
simplify the composition of interest rates, we will look at nominal interest rates being composed of
five driving forces, as outlined here:

Nominal interest rate = r = r* + IP + DRP + LP + MRP

Here r* represents the real risk-free rate of interest, IP is the inflation premium, DRP is the default
risk premium, LP is the liquidity premium, and MRP is the maturity risk premium. Together, these
five factors determine the nominal interest rate, denoted by r.
WHICH TYPES OF SECURITIES ARE EXPOSED TO WHAT KIND OF RISK?
Interest Rate Short-Term Long-Term Short-Term Long-Term
Parameter Treasuries Treasuries Corporates Corporates
r*
X
X
X
X
IP
X
X
X
X
MRP
X
X
DRP
X
X
LP
X
X

THE TERM STRUCTURE OF INTEREST RATES (Section 6.4)

The term structure describes the relationship between long-term and short-term interest rates.
Graphically, this relationship can be shown in what is known as the yield curve. In practice, the yield
curve is relatively easy to obtain. It is published daily in a variety of online and print news sources.
However, the "building block approach" to generating a yield curve is more complicated. We will see
that later when we build our own yield curve.

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28
29
30
31
32
33

Before jumping into the creation of our own yield curve, let's look at some historical interest rate
data and draw some historical yield curves. Here is some interest rate data from March 1980, August
1999, and February 2000.
Maturity (yrs)

0.5
1
5
20
30

Mar-80
15.0%
14.0%
13.5%
12.8%
12.3%

Feb-00
6.0%
6.2%
6.7%
6.7%
6.3%

Feb-05
2.9%
3.1%
3.8%
4.2%
4.6%

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45
46
47
48
49
50
51
52
53
54
55
56
57

From this data, we can plot three line graphs. Each line graph represents the U.S. Treasury yield
curve at a different point in time.

U.S. Treasury Bond Interest Rates on Different Dates

Interest Rate
(%)

16.0%

Yield Curve for March 1980

(Current Rate of Inflation: 12%)

14.0%
12.0%
10.0%

Yield Curve for February 2000

(Current Rate of Inflation: 3%)

8.0%
6.0%
4.0%

Yield Curve for February 2005

(Current Rate of Inflation: 2.5%)

2.0%
0.0%
0
Short Term

5
Intermediate
Term

10

15

20
Long Term

Years
25to Maturity

30

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A
B
C
D
E
F
G
H
Then, we reproduce the data from the graph in this table, to make it look like it might have appeared
in the newspaper.

Term to Maturity
6 months
1 year
5 years
10 years
30 years

March 1980
15.0%
14.0%
13.5%
12.8%
12.3%

Interest Rate
February 2000
6.0%
6.2%
6.7%
6.7%
6.3%

February 2005
2.9%
3.1%
3.8%
4.2%
4.6%

Looking at these three historical yield curves, we see that they paint very different landscapes of the
financial environment at those times. In the March 1980 yield curve, we see that the yield curve was
"downward sloping" as a result of the expectation that inflation would be decreasing. Hence, shortterm interest rates offered greater yields than long-term rates. In February 2000, we see an odd
development in the yield curve. At this point in time, the yield curve was "humped". Looking at the
graph, we see that intermediate range securities offered the highest yields. This results from an odd
combination of inflation expectations and concerns about maturity. In February 2005, we observed a
financial environment in which there was low current inflation, and inflation was expected to rise.
Hence, there was an "upward sloping" yield curve.

WHAT DETERMINES THE SHAPE OF THE YIELD CURVE? (Section 6.5)

Now that we have experimented with historical interest rate data, we will move on and create our
own yield curve. This yield curve will be based upon whatever assumptions we feel like setting.

Our Hypothetical Yield Curve

First, we will assume that the real risk-free rate of interest is 2.5%. Furthermore, we expect inflation
to be 3% for the next three years, 4% for the next four years, and 5% thereafter. That allows us to
piece together two components of Treasury securities. To estimate the maturity risk premium, a
formula has been devised to give reasonable MRP estimates. Don't read anything into the equation
for MRP (as we made it up), although we do think its results are reasonable. The formula we used to
calculate the MRP was:
MRPt =

0.1*((1/t)^1/2)*(t1)%

Setting up the yield curve

Now, we want to put all of these elements together. The second column shows the expected real
risk-free rate of interest (constant at 2.5%). The third column shows the inflation premium
(determined by the stated inflation expectations). The fourth column shows the maturity risk
premium (determined from the formula outlined above).
INPUT DATA
Real risk free rate

2.50%

A
86
87
88
89

Expected inflation of
Expected inflation of
Expected inflation of

C
3%
4%
5%

D
for the next
for the next
thereafter.

E
3
4

F
years.
years.

90

91

Note: You will notice that according to our inflation projections, inflation would be a constant 3% for
three years, and then suddenly jump to 4% in the fourth year. This would suggest that the IP is a
constant 3% throughout the first three years. If you let this happen, you will observe a sudden
"kink" in your curve at the fourth year. Ideally, you would like the smoothest and most realistic
curve as possible. For that reason, we have manually forced the inflation premium in years 1 and 2
to 3.1% and 3.2%, respectively. To repeat, we have done this just to make the curve more visually
appealing, and because it does seem logical that growth in inflation would be a gradual, rather than
a sudden process.

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YIELD CURVE INFORMATION

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106
107
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109
110
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112
113
114
115
116
117
118
119
120
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122
123
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125
126

Years to
Maturity
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
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27
28
29
30

Real RiskFree Rate

(r*)
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%

Inflation
Premium
(IP)
3.00%
3.10%
3.20%
3.25%
3.40%
3.50%
3.57%
3.75%
3.89%
4.00%
4.09%
4.17%
4.23%
4.29%
4.33%
4.38%
4.41%
4.44%
4.47%
4.50%
4.52%
4.55%
4.57%
4.58%
4.60%
4.62%
4.63%
4.64%
4.66%
4.67%

Maturity
Risk
Premium
(MRP)
0.00%
0.07%
0.12%
0.15%
0.18%
0.20%
0.23%
0.25%
0.27%
0.28%
0.30%
0.32%
0.33%
0.35%
0.36%
0.38%
0.39%
0.40%
0.41%
0.42%
0.44%
0.45%
0.46%
0.47%
0.48%
0.49%
0.50%
0.51%
0.52%
0.53%

Treasury
Yield
5.50%
5.67%
5.82%
5.90%
6.08%
6.20%
6.30%
6.50%
6.66%
6.78%
6.89%
6.98%
7.06%
7.13%
7.19%
7.25%
7.30%
7.35%
7.39%
7.42%
7.46%
7.49%
7.52%
7.55%
7.58%
7.61%
7.63%
7.65%
7.68%
7.70%

The table above gives us all of the components for our Treasury yield curve. Recall, we have said
that Treasury securities are subject to two kinds of risk premiums, the inflation premium and the
127
maturity risk premium. Just as we "built" Treasury yields in the table, we can "build" a yield curve
based upon these expectations.
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When Inflation Is Expected To Increase

Interest Rate
(%)

8.00%

Maturity risk
premium

7.00%
6.00%

Inflation
premium

5.00%
4.00%
3.00%
2.00%

Real riskfree rate

1.00%
0.00%

10

Maturity
1 year
5 years
10 years
20 years
30 years

Years to Maturity

20

30

With increasing expected inflation

r*
IP
MRP
Yield
2.50%
3.00%
0.00%
5.50%
2.50%
3.40%
0.18%
6.08%
2.50%
4.00%
0.28%
6.78%
2.50%
4.50%
0.42%
7.42%
2.50%
4.67%
0.53%
7.70%

In this yield curve, the assumptions we made maintained that inflation was to increase, but this is
not always the case. For proof look at the March 1980 yield curve from above.

160
161 What If Inflation Is Expected To Decrease?
Now, we will construct a similar yield curve, except we will change inflation expectations. Instead of
increasing inflation, we will have decreasing inflation. We will assume that: inflation is expected to
162
be 5% for the next three years, 4% for the following 4 years, and 3% thereafter. All of our other
previous assumptions will be upheld.
163
164 Real risk free rate
165
166 Expected inflation of
167 Expected inflation of

2.5%
5.0%
4.0%

for the next

for the next

3
4

years.
years.

A
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C
D
E
F
G
H
3.0%
thereafter.
168 Expected inflation of
169
Our methodology for creating this yield curve's data will be exactly the same as above. In fact, we
170
will use all of the same formulas.

Years to
Maturity
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
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26
27
28
29
30

Real RiskFree Rate

(r*)
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%

Inflation
Premium
(IP)
5.00%
4.95%
4.85%
4.75%
4.60%
4.50%
4.43%
4.25%
4.11%
4.00%
3.91%
3.83%
3.77%
3.71%
3.67%
3.63%
3.59%
3.56%
3.53%
3.50%
3.48%
3.45%
3.43%
3.42%
3.40%
3.38%
3.37%
3.36%
3.34%
3.33%

Maturity
Risk
Premium
(MRP)
0.00%
0.07%
0.12%
0.15%
0.18%
0.20%
0.23%
0.25%
0.27%
0.28%
0.30%
0.32%
0.33%
0.35%
0.36%
0.38%
0.39%
0.40%
0.41%
0.42%
0.44%
0.45%
0.46%
0.47%
0.48%
0.49%
0.50%
0.51%
0.52%
0.53%

Treasury
Yield
7.50%
7.52%
7.47%
7.40%
7.28%
7.20%
7.16%
7.00%
6.88%
6.78%
6.71%
6.65%
6.60%
6.56%
6.53%
6.50%
6.48%
6.46%
6.44%
6.42%
6.41%
6.40%
6.39%
6.39%
6.38%
6.37%
6.37%
6.37%
6.36%
6.36%

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215
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When Inflation Is Expected To Decrease

Interest Rate
(%)

8.00%
7.00%
Maturity risk
premium

6.00%
5.00%

Inflation
premium

4.00%
3.00%
2.00%

Real riskfree rate

1.00%
0.00%
Years to Maturity

20

30

7.00%
Maturity risk
premium

6.00%
5.00%

Inflation
premium

4.00%

A
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233

3.00%

2.00%

Real riskfree rate

1.00%
0.00%

10

Maturity
1 year
5 years
10 years
20 years
30 years

Years to Maturity

20

30

With decreasing expected inflation

r*
IP
MRP
Yield
2.50%
5.00%
0.00%
7.50%
2.50%
4.60%
0.18%
7.28%
2.50%
4.00%
0.28%
6.78%
2.50%
3.50%
0.42%
6.42%
2.50%
3.33%
0.53%
6.36%

To this point, we have constructed two yield curves based upon hypothetical data. The first yield
curve operates under the simple assumption that inflation is expected to rise in the future. To some
extent, actual yield curves are constructed in similar ways. The true Treasury yield curve is
234
determined by graphing Treasury security yields of varying maturities. Every security's yield is based
upon investor attitudes and expectations regarding future market conditions. In other words, the
sort of "building" we have done with our yield curves sort of occurs implicitly for every security.
235
236 CORPORATE BONDS
So far, we have addressed the yield curve construction for Treasury securities, but can corporate
237
bonds also be demonstrated in yield curve fashion?
238
The answer is yes. Remember, that the primary difference between Treasury and corporate
securities is the different yield premiums to which each is subject. We have demonstrated
239 previously that Treasury securities carry an inflation premium and a maturity risk premium. We also
have said that corporate securities require two additional premiums: a default risk premium and a
liquidity premium.
240
241 Default Risk Premiums and the Liquidity Premium
The construction of corporate yields is a process of beginning with the appropriate Treasury yield
curve and adding in these two final yield premiums. However, the determination of these premiums
can be tricky. It seems logical that default risk on corporate bonds should somehow be a function of
the firm's corporate bond rating. Apart from that we have little guidance regarding the determination
242 of the default risk premium. However, we could assume that the relationship between corporate
bonds of a given rating and Treasury securities of the same maturity would have a fairly stable
relationship. By that token, we might be able to derive a good point estimator of the default risk
premium by looking at the recent average default spread for different rated corporate bonds. This
information is in the text, and is as follows:
243

A
244
245
246
247
248
249

B
Bond
Rating
AAA
AA
A
BBB

C
Default
spread
0.80%
0.95%
1.13%
1.69%

This tells us the average default spreads of corporate securities with various bond ratings. We will
use this data as the starting point for our corporate yield curves. Naturally, the first question that
arises is, "Does the default risk premium change, or does it always stay the same?" Logically, the
idea of a time-varying default risk premium seems fairly plausible. The longer the maturity of the
250
security, the greater the possibility of default. Therefore, we need some sort of mechanism for
simulating this relationship. Just as we did for the maturity risk premium, we will "manufacture" a
relationship by which the default risk premium interacts with the time to maturity. The following
formula is simply made up, but it gives us a default relationship with which we are comfortable.
251
252
253

DRP t = Default spread * (1.02)(t1)

Lastly, we need to consider the liquidity premium. Liquidity is very difficult to measure, and it is not
254 a vital concern for many widely-traded securities. Therefore, this exercise will assume there is no
liquidity premium on AA-rated bonds.
255
256 With all of that having been said, we can step forward and try to construct corporate yield curves.
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260
261
262

Real risk free rate

2.50%

Expected inflation of
Expected inflation of
Expected inflation of

3%
4%
5%

for the next

for the next
thereafter.

3
4

years.
years.

263
Naturally, yield curves can be created for corporate bonds of any rating. However, we have chosen
to create curves for only AA and BBB-rated bonds. This exercise is for purely illustrative purposes,
264
so rather than complicate the graph with a lot of curves, we will create two curves to show the
relationship between yield curves.
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300
301
302
303
304
305

Years to
Maturity
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30

Real RiskFree Rate

(r*)
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%
2.50%

Inte re st Rate
(%)

Inflation
Premium
(IP)
3.00%
3.10%
3.20%
3.25%
3.40%
3.50%
3.57%
3.75%
3.89%
4.00%
4.09%
4.17%
4.23%
4.29%
4.33%
4.38%
4.41%
4.44%
4.47%
4.50%
4.52%
4.55%
4.57%
4.58%
4.60%
4.62%
4.63%
4.64%
4.66%
4.67%

Maturity
Risk
Premium
(MRP)
0.00%
0.07%
0.12%
0.15%
0.18%
0.20%
0.23%
0.25%
0.27%
0.28%
0.30%
0.32%
0.33%
0.35%
0.36%
0.38%
0.39%
0.40%
0.41%
0.42%
0.44%
0.45%
0.46%
0.47%
0.48%
0.49%
0.50%
0.51%
0.52%
0.53%

Treasury
Yield
5.50%
5.67%
5.82%
5.90%
6.08%
6.20%
6.30%
6.50%
6.66%
6.78%
6.89%
6.98%
7.06%
7.13%
7.19%
7.25%
7.30%
7.35%
7.39%
7.42%
7.46%
7.49%
7.52%
7.55%
7.58%
7.61%
7.63%
7.65%
7.68%
7.70%

AA-Rated AA-Rated BBB-Rated

DRP
Bond Yield
DRP
0.95%
6.45%
1.69%
0.97%
6.64%
1.72%
0.99%
6.80%
1.76%
1.01%
6.91%
1.79%
1.03%
7.11%
1.83%
1.05%
7.25%
1.87%
1.07%
7.37%
1.90%
1.09%
7.59%
1.94%
1.11%
7.77%
1.98%
1.14%
7.92%
2.02%
1.16%
8.05%
2.06%
1.18%
8.17%
2.10%
1.20%
8.27%
2.14%
1.23%
8.36%
2.19%
1.25%
8.45%
2.23%
1.28%
8.53%
2.27%
1.30%
8.60%
2.32%
1.33%
8.68%
2.37%
1.36%
8.74%
2.41%
1.38%
8.81%
2.46%
1.41%
8.87%
2.51%
1.44%
8.93%
2.56%
1.47%
8.99%
2.61%
1.50%
9.05%
2.66%
1.53%
9.11%
2.72%
1.56%
9.16%
2.77%
1.59%
9.22%
2.83%
1.62%
9.27%
2.88%
1.65%
9.33%
2.94%
1.69%
9.38%
3.00%

Corporate and Treasury

Yield Curves

12.00%
BBB-Rated Bond

10.00%
AA-Rated Bond

8.00%
6.00%

Treasury Yield Curve

Corporate and Treasury

Yield Curves

Inte re st Rate
(%)

12.00%
BBB-Rated Bond

A 10.00%
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320

H
AA-Rated Bond

8.00%

Treasury Yield Curve

6.00%
4.00%
2.00%
0.00%

10

Years to Maturity

20

Looking at the yield curve we have constructed, we see a relationship that we should have expected.
We see that at any length to maturity, the yield on corporate bonds is always greater than the yield
on Treasuries. This is logical because corporate securities carry a default risk, and Treasuries do
321
not. Furthermore, we observe that at any length to maturity the corporate security with the lower
rating always has a higher yield than a corporate bond with a higher rating. Once again, this is a
logical conclusion. Remember, greater risk should result in a higher yield.
322
323
324 USING THE YIELD CURVE TO ESTIMATE FUTURE INTEREST RATES (Section 6.6)
The shape of the yield curve depends primarily on two key factors: (1) expectations about future
inflation and (2) perceptions about the relative riskiness of securities of different maturities. The first
factor is the basis for the Pure Expectations Hypothesis. If the relationship between expectations for
future inflation and bond yields is controlling, i. e., if no maturity premiums existed, then the pure
325
expectations theory posits that forward interest rates can be predicted by "backing them out of the
yield curve." Essentially, under the pure expectations theory, long-term security rates are a weighted
average of the yields on all the shorter maturities that make up the longer maturity. This calculation
will hold true, providing that the MRP=0 assumption is valid.
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327

For instance, if the yield on a 1-year bond is 5% and that on a 2-year bond is 6%, the rate on a 1-year
bond one year from now should be 7%, because (1.06)2 = (1.05)(1.07).

328
Generally, r designates the rate, or yield, and our notation involves two subscripts. The first
subscript denotes when in the future we expect the yield to exist, and the second denotes the
329 maturity of the security. For instance, the rate expected 3 years from now on a 2-year bond would be
denoted by 3r2.
330
331 PROBLEM
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333

Assuming that expectations theory holds, use the yield information below to back out the following
forward rates from the yield curve.

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A
B
C
D
Expected forward rates, in words:
Yield on 1-year bond 1 year from now
=
Yield on 1-year bond 2 years from now =
Yield on 1-year bond 3 years from now =
Yield on 1-year bond 4 years from now =
Yield on 5-year bond 5 years from now =
Yield on 10-year bond 10 years from now =
Yield on 20-year bond 10 years from now =
Yield on 10-year bond 20 years from now =

E
Symbol:
r
1 1
r
2 1
r
3 1
r
4 1
r
5 5
r
10 10
r
10 20
r
20 10

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365
366
367
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369
370
371
372
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375
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377
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380
381

B
Maturity
1 year
2 year
3 year
4 year
5 year
10 year
20 year
30 year

C
Maturity
1
2
3
4
5
10
20
30

D
Yield
5.02%
5.31%
5.48%
5.65%
5.73%
5.68%
6.01%
5.92%

(1+ r2)2

=
=
=

(
(

(1 + r1)

x
x

(1 + 1r1)
(1 + 1r1)

=
=
=

(
(

(1+ r2)2

x
x

(1 + 2r1)
(1 + 2r1)

=
=
=

(
(

(1+ r3)3

x
x

(1 + 3r1)
(1 + 3r1)

(
(

(1+ r4)4

1.3213
r
4 1

=
=
=

x
x

(1 + 4r1)
(1 + 4r1)

(1+ r10)10

(1+ r5)5

(1 + 5r5)5

1.7375
r
5 5

=
=

1.3213
5.63%

(1 + 5r5)5

(1+ r20)20

(1+ r10)10

(1 + 10r10)10

3.2132
r
10 10

=
=

1.7375
6.34%

(1 + 10r10)10

(1+ r30)30

(1+ r20)20

(1 + 20r10)10

5.6149
r
20 10

=
=

3.2132
5.74%

(1 + 20r10)10

1.1090
r
1 1
(1+ r3)3
1.1736
r
2 1
(1+ r4)4
1.2459
r
3 1
(1+ r5)5

1.0502
5.60%

1.1090
5.82%

1.1736
6.16%

1.2459
6.05%

The data used to construct the yield curve are readily available, and forward rates can be calculated
as shown above. Bond traders and corporate borrowers can use this information for hedging in the
futures market. For example, if a company plans to build a new plant two years from now and wants
382 to be assured of getting the required funds at a specified rate, then it can buy a bond futures
contract that will enable it to "lock in" the cost of debt for the project. The treasurer would go
through the process described above to determine what the rate two years hence should be on
bonds with the desired maturity.

A
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Dates

Maturity

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Maturity risk
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premium
135
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143
Real
riskfree
rate
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210
Maturity
211 risk
premium
212
213
Inflation
214
premium
215
216

Real riskfree rate

30

Maturity risk
premium
Inflation
premium

30

217
218
Real
risk219
free rate
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BBB-Rated
Bond Yield
7.19%
7.39%
7.57%
7.69%
7.91%
8.07%
8.20%
8.44%
8.64%
8.80%
8.95%
9.09%
9.21%
9.32%
9.42%
9.52%
9.62%
9.71%
9.80%
9.89%
9.97%
10.05%
10.14%
10.22%
10.30%
10.38%
10.46%
10.54%
10.62%
10.70%

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293
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296
297
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299
300
301
302
303
304
BBB-Rated
Bond
305
AA-Rated Bond

Treasury Yield Curve

BBB-Rated Bond

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AA-Rated Bond
307
Treasury 308
Yield Curve
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315
316
317
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320

321

322
323
324

325

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327
328
329
330
331
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333

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SECTION 6.2
SOLUTIONS TO SELF-TEST QUESTIONS
5a If inflation during the last 12 months was 2% and the interest rate during that period was
5%, what was the real rate of interest?
Inflation
Nominal interest rate

2.0%
5.0%

Real rate of interest

3.0%

5b If inflation is expected to average 4% during the next year and the real rate is 3%, what
should the current rate of interest be?
Inflation
Real rate of interest

4.0%
3.0%

Nominal rate of interest

7.0%

SECTION 6.3
SOLUTIONS TO SELF-TEST QUESTIONS
7a Assume that the real risk-free rate is r* = 2% and the average expected inflation rate is 3%
for each future year. The DRP and LP for Bond X are each 1%, and the applicable MRP is 2%.
What is Bond Xs interest rate?
r*
Inflation Premium
Default Risk Premium
Liquidity Premium
Maturity Risk Premium

2.0%
3.0%
1.0%
1.0%
2.0%

Real rate of interest

9.0%

SECTION 6.6
SOLUTIONS TO SELF-TEST QUESTIONS
5a Assume the interest rate on a 1-year T-bond is currently 7% and the rate on a 2-year bond is
9%. If the maturity risk premium is zero, what is a reasonable forecast of the rate on a 1-year
bond next year?
1-year Treasury yield
2-year Treasury yield
Maturity Risk Premium

7.0%
9.0%
0.0%

1-year rate, 1 year from now

11.04%

5b What would the forecast be if the maturity risk premium on the 2-year bond were 0.5% and it
was zero for the 1-year bond?
1-year Treasury yield
2-year Treasury yield
Maturity Risk Premium
1-year rate, 1 year from now

7.0%
9.0%
0.5%
10.02%