For every question, please write down each main step before you obtain the final

Question

For every question, please write down each main step before you obtain the final answer. Correct final answer with incorrect related work (calculation) or without any work may receive 0 point. On the contrary, incorrect final answer with correct related work (calculation) will receive partial credits.

Question 2 – Inflation Premium [4 points]: Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 10 percent, and 9 percent, respectively. What is the inflation premium on a three-year bond (i.e., IP3), and what is the inflation premium on a five-year bond (i.e., IP5)?

Explanation / Answer

Inflation premium = average of the expected inflation over the life of the bond

So,

IP3 (inflation premium for 3 year bond) = (4%+7%+10%)/3

IP3 (inflation premium for 3 year bond) = 7%

IP5 (inflation premium for 5 year bond) = (4%+7%+10%+10% + 9%)/5

IP5 (inflation premium for 5 year bond) = 8%

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