Assume that the risk free rate of return r*, is 3 percent, and it will remain at

Question

Assume that the risk free rate of return r*, is 3 percent, and it will remain at that level far in to the future. also assume that maturity risk premiums on treasury bonds increase from zero for bonds that mature in one year or less to a maximum of 2 percent and MRP increases by 0.2 percent for each yearto maturity that is greater than one year-that is , MRP equals 0.2 percent for a two year bond, 0.4 percent for a three year bond and so forth. Following are the expected inflation rates for the next five years:
2009- 3%
2010- 5%
2011- 4%
2012- 8%
2013- 3%

A. what is the average expected inflation rate for a one- , two-, three-, four- and five- year bond?
B. what should be the MRP for a one, two, three, four and five year bond?
C. compute the interest rate for a one, two, three, four and five year bond?
D. if inflation is expected to equal 2 percent every year after 2013, what should the interest rate be for a 10- and 20-year bond?
E. Plot the yield curve for the interest rates you computed in parts c and d.

Explanation / Answer

A. average expected inflation rate for a one year bond =3% average expected inflation rate for a two year bond =(3+5)/2 = 4% average expected inflation rate for a three year bond =(3+5+4)/3 = 4% average expected inflation rate for a four year bond =(3+5+4+8)/4 = 5% average expected inflation rate for a five year bond =(3+5+4+8+3)/5 = 4.6% B. MRP for a one year bond =0% MRP for a two year bond =0.2% MRP for a three year bond =0.2%*2 =0.4% MRP for a four year bond =0.2%*3 =0.6% MRP for a five year bond =0.2%*4 =0.8%

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.