6 INFLATION CROSS-PRODUCT An analyst is evaluating securities in a developing na

Question

6 INFLATION CROSS-PRODUCT An analyst is evaluating securities in a developing nation where the inflation rate is very high. As a result, the analyst has been warned not to ignore the cross-product between the real rate and inflation. If the real risk-free rate is 5% and inflation is expected to be 18% each of the next 4 years, what is the yield on a 4-year security with no maturity, default, or liquidity risk? (Hint: Refer to "The Links between Expected Inflation and Interest Rates: A Closer Look" on page 206.)

Explanation / Answer

As we know (1+ R) = (1+ r) / (1+ i)

Where (R) = Real Interest Rate, (r) = Nominal Interest Rate and (i) =Rate of Inflation

Since there is no default risk, maturity or liquidity risk. The yield on Security will be equal to the nominal interest rate.

As per formula:

(1+0.05)4 = (1+r) 4 / (1+0.18)4

(1+r) 4 = (1+0.05)4 * (1+0.18)4

(1+r) 4 = 2.35659648464

(1+r) = (2.35659648464)1/4

Note: (2.35659648464)1/4 = two times square root.

1+r =1.23899

So r= 0.23899 or 23.899%

So the yield on the security is 23.899%

Related Questions

Navigate

• Browse (All)
• Browse 6
• Subjects

---

---

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