In late 1980, the U.S. Commerce Department released new data showing inflation w
ID: 2735096 • Letter: I
Question
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 13%; for 1982, 9%; for 1983, 7%; and for 1984 and thereafter, 6%. a. What was the average expected inflation rate over the 5-year period 1981–1985? (Use the arithmetic average.) b. Over the 5-year period, what average nominal interest rate would be expected to produce a 2% real risk-free return on 5-year Treasury securities? Assume MRP 0. c. Assuming a real risk-free rate of 2% and a maturity risk premium that equals 0.1 × (t)%, where t is the number of years to maturity, estimate the interest rate in January 1981 on bonds that mature in 1, 2, 5, 10, and 20 years. Draw a yield curve based on these data. d. Describe the general economic conditions that could lead to an upward-sloping yield curve. e. If investors in early 1981 expected the inflation rate for every future year to be 10% (i.e., It It 1 10% for t 1 to, what would the yield curve have looked like? Consider all the factors that are likely to affect the curve. Does your answer here make you question the yield curve you drew in part c? Challenging Problems 17–19 214 Part 3 Financial Assets Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Brigham, Eugene F.; Houston, Joel F.. Fundamentals of Financial Management (Finance Titles in the Brigham Family) (Page 214). South-Western College Pub. Kindle Edition.
Explanation / Answer
Answer:a Avg Inflation Rate=(.13+.09++0.07+.06+.06)/5 = 8.20%
Answer:b R=r8+IPavg
R=2%+8.2%
R=10.2%
Answer:d.An expectation of rising interest rates, same IP for all maturities while MRP rises, and during a recession the inflation and short term rates are low creating a steep slope in the yield curve.
Answer:e A constant inflation rate would make the yield curve flat, based on the expectation theory. Using the greater risk of long term bonds, the maturity risk premium would be applied and added to the yield curve, making it more normal with the long term end on the rise.
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