Problem 6-16 Inflation Cross-Product An analyst is evaluating securities in a de
ID: 2614185 • Letter: P
Question
Problem 6-16
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. A 6-year security with no maturity, default, or liquidity risk has a yield of 14.8%. If the real risk-free rate is 6.5%, what average rate of inflation is expected in this country over the next 6 years? Round your answer to two decimal places. (Hint: Refer to "The Links Between Expected Inflation and Interest Rates: A Closer Look.")
Explanation / Answer
Based on the Fischer relation,
(1 + Nominal Rate of Return) = (1 + Real Rate of Return) * (1 + Inflation Rate)
{Note: Some texts refer to this formula in a simplified way: Nominal rate = Real rate + Inflation, but this is an approximate formula, whereas the one mentioned above is exact, both will yield close by results).
(1 + 14.8%) = (1 + 6.5%) * (1 + Inflation)
=> Inflation = 7.79%