Question

P6–5 Nominal interest rates and yield curves A recent study of inflationary expectations has revealed that the consensus among economic forecasters yields the following average annual rates of inflation expected over the periods noted.
(Note: Assume that the risk that future interest rate movements will affect longer maturities more than shorter maturities is zero; that is, assume that there is no maturity risk.)

Period Average annual rate of inflation
3 months 5%
2 years 6
5 years 8
10 years 8.5
20 years 9

a. If the real rate of interest is currently 2.5%, find the nominal rate of interest on
each of the following U.S. Treasury issues: 20-year bond, 3-month bill, 2-year
note, and 5-year bond.
b. If the real rate of interest suddenly dropped to 2% without any change in
inflationary expectations, what effect, if any, would it have on your answers in
part a? Explain.
c. Using your findings in part a, draw a yield curve for U.S. Treasury securities.
Describe the general shape and expectations reflected by the curve.
d. What would a follower of the liquidity preference theory say about how the
preferences of lenders and borrowers tend to affect the shape of the yield
curve drawn in part c? Illustrate that effect by placing on your graph a
dotted line that approximates the yield curve without the effect of liquidity
preference.
e. What would a follower of the market segmentation theory say about the supply
and demand for long-term loans versus the supply and demand for short-term
loans given the yield curve constructed for part c of this problem?

Please show excel formulas or equations if possible. Thank you in advance!

Answer 1