Hi, can you please answer these questions :) Thanks! In late 1980, the U.S. Comm

Question

Hi, can you please answer these questions :) Thanks!

In late 1980, the U.S. Commerce Department released new data showing inflation was 15%. At the time, the prime rate of interest was 21%, a record high. However, many investors expected the new Reagan administration to be more effective in controlling inflation than the Carter administration had been. Moreover, 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 lead to a recession, which, in turn, would lead to a decline in inflation and interest rates. Assume that at the beginning of 1981, the expected inflation rate for 1981 was 14%; for 1982, 10%; for 1983, 8%; and for 1984 and thereafter, 6%.

a.) Assuming a real risk-free rate of 3% 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 year. Round your answer to two decimal places.

b.) Assuming a real risk-free rate of 3% 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 2 years. Round your answer to two decimal places.

c.Assuming a real risk-free rate of 3% 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 3 years. Round your answer to two decimal places.

d.) Assuming a real risk-free rate of 3% 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 5 years. Round your answer to two decimal places.

e.) Assuming a real risk-free rate of 3% 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 10 years. Round your answer to two decimal places.

f.) Assuming a real risk-free rate of 3% 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 20 years. Round your answer to two decimal places.

Explanation / Answer

a. For 1 year, interest rate = 3 + 14 + 0.1 = 17.1% where 14 is the inflation rate for 1 year

b. For 2 years:

Inflation rate = (1.14*1.10)^(1/2) -1 = 11.98%

Interest rate = 3 + 11.98 + 0.1*2 = 15.18%

c. For 3 years

Inflation rate = (1.14*1.10*1.08)^(1/3)-1 = 10.64%

Interest rate = 3 + 10.64 + 0.1*3 = 13.94%

d. For 5 years

Inflation rate = (1.14*1.10*1.08*1.06^2)^(1/5)-1 = 8.76%

Interest rate = 3 + 8.76+ 0.1* 5 = 12.26%

e. For 10 years,

Infation rate = (1.14*1.10*1.08*1.06^7)^(1/10) -1 = 7.37%

Interest rate = 3+7.37 + 0.1*10 = 3+7.37 +1 = 11.37%

f. For 20 years,

Inflation rate = (1.14*1.10*1.08*1.06^17)^(1/20) -1 = 6.68%

Interest rate = 3 + 6.68 + 0.1*20 = 3+6.68 +2 = 11.68%

Related Questions

Navigate

• Browse (All)
• Browse H
• Subjects

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