Assume that the real risk-free rate of return, k*, is 3%, and it will remain at that level far into the future. Also assume that maturity risk premiums (MRP) increase from zero for bonds that mature in one year or less to a maximum of 1%, and MRP increases by 0.2% for each year to maturity that is greater than one year-that is, MRP equals 0.2% for two-year bond, 0.4% for a three-year bond, and so forth. Following are the expected inflation rates for the next five years: Year Inflation Rate (%) 2017 5 2018 6 2019 7 2020 8 2021 9 a) Compute the interest rate for a one-, two-, three-, four-, and five-year bond. b) If inflation is expected to equal 9% every year after 2021, what should be the interest rate for a 10- and 20-year bond? c) Plot the yield curve for the interest rates you computed in part [a] and [b]. d) Based on the curve (in part c), interpret your findings.
Assume that the real risk-free
|
Year |
Inflation Rate (%) |
|
2017 |
5 |
|
2018 |
6 |
|
2019 |
7 |
|
2020 |
8 |
|
2021 |
9 |
a) Compute the interest rate for a one-, two-, three-, four-, and five-year bond.
b) If inflation is expected to equal 9% every year after 2021, what should be the interest rate for a 10- and 20-year bond?
c) Plot the yield curve for the interest rates you computed in part [a] and [b].
d) Based on the curve (in part c), interpret your findings.
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