In late 1980 the US Commerce Department released new figures which showed that inflation was running at an annual rate of close to 15 percent. However, many investors expected the new Reagan administration to be more effective incontrolling inflation than the Carter administration had been. At the time, the prime rate of interest was 21 percent, a record high. However many observers believed that the extremely high interest rates and generally tight credit, which resulted from the Federal Reserve System's attempts to curb the inflation rate, would shortly bring back a recession, which in turn would lead to a decline in the inflation rate and also in the rate of interest. Assume that at the beginning of 1981 the expecte rate of inflation for 1981 was 13 percent; for 1982, 9 percent; for 1983, 7 percent ; and for 1984 and thereafter, 6 percent.
Assuming a real risk-free rate of 2% and a maturity risk premium that equals 0.1 x (t)% where t is the number of years to maturity, estimate the interest rate in January 1981 on bonds that mature in 1, 2, 5, 10 and 20 years. Draw a yield curve based on these data.