Chapter 6 Interest Rates 177Therefore, the best forecast for the future value of r* is its current value. However,
the in" ation premium, IP, varies signi! cantly over time and in a somewhat pre-
dictable manner. Recall that the in" ation premium is the average level of expected
in" ation over the life of the bond. Thus, if the market expects in" ation to increase
in the future (say, from 3% to 4% to 5% over the next 3 years), the in" ation pre-
mium will be higher on a 3-year bond than on a 1-year bond. On the other hand, if
the market expects in" ation to decline in the future, long-term bonds will have a
smaller in" ation premium than will short-term bonds. Finally, since investors con-
sider long-term bonds to be riskier than short-term bonds because of interest rate
risk, the maturity risk premium always increases with maturity.
Panel a of Figure 6-5 shows the yield curve when in" ation is expected to in-
crease. Here long-term bonds have higher yields for two reasons: (1) In" ation is
expected to be higher in the future, and (2) there is a positive maturity risk pre-
mium. Panel b shows the yield curve when in" ation is expected to decline. Such a
downward-sloping yield curve often foreshadows an economic downturn because
Illustrative Treasury Yield Curves
F I G U R E 6! 5WITH INFLATION
EXPECTED TO INCREASEWITH INFLATION
EXPECTED TO DECREASEMaturity r IP MRP Yield Maturity r IP MRP Yield
1 year 2.50% 3.00% 0.00% 5.50% 1 year 2.50% 5.00% 0.00% 7.50%
5 years 2.50 3.40 0.18 6.08 5 years 2.50 4.60 0.18 7.28
10 years 2.50 4.00 0.28 6.78 10 years 2.50 4.00 0.28 6.78
20 years 2.50 4.50 0.42 7.42 20 years 2.50 3.50 0.42 6.42
30 years 2.50 4.67 0.53 7.70 30 years 2.50 3.33 0.53 6.36
Interest Rate
(%)a. When In"ation Is Expected to IncreaseInterest Rate
(%)b. When In"ation Is Expected to Decrease8 7 6 5 4 3 2 1Years to MaturityMaturity
Risk
PremiumIn"ation
PremiumReal Risk-
Free Rate8 7 6 5 4 3 2 1Years to MaturityMaturity
Risk
PremiumIn"ation
PremiumReal Risk-
Free Rate(^01020300102030)