Inflation Due to a recession, expected inflation this year is only 2.75%. Howeve
ID: 2637911 • Letter: I
Question
Inflation
Due to a recession, expected inflation this year is only 2.75%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 2.75%. Assume that expectations theory holds and the real risk-free rate is r* = 2.25%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 2.25%, what inflation rate is expected after Year 1? Round your answer to two decimal places.
Default Risk Premium
The real risk-free rate, r*, is 3.1%. Inflation is expected to average 2.75% a year for the next 4 years, after which time inflation is expected to average 4.65% a year. Assume that there is no maturity risk premium. An 8-year corporate bond has a yield of 10.4%, which includes a liquidity premium of 0.9%. What is its default risk premium? Round your answer to two decimal places.
Interest Rate Premiums
A 5-year Treasury bond has a 3.7% yield. A 10-year Treasury bond yields 6.8%, and a 10-year corporate bond yields 8.2%. The market expects that inflation will average 1.5% over the next 10 years (IP10 = 1.5%). Assume that there is no maturity risk premium (MRP = 0), and that the annual real risk-free rate, r*, will remain constant over the next 10 years. (Hint: Remember that the default risk premium and the liquidity premium are zero for Treasury securities: DRP = LP = 0). A 5-year corporate bond has the same default risk premium and liquidity premium as the 10-year corporate bond described above. What is the yield on this 5-year corporate bond? Round your answer to two decimal places.
Explanation / Answer
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Due to a recession, expected inflation this year is only 3%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 3%. Assume that expectations theory holds and the real risk-free rate is r* = 2.5%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 1.5%, what inflation rate is expected after Year 1? Round your answer to two decimal places.
Ans
Expected inflation in Year1 is 3%
For 1 year Treasury bonds
Yield1= risk free rate + expected inflation + maturity risk premium
Yield1 = 2.5% + 3% + MRP
For 3 year Treasury bonds
Yield3= risk free rate + expected inflation + maturity risk premium
= 2.5% + IP3 + MRP
Yield3 = Yield1 + 1.5%
2.5% + IP3 + MRP = 2.5% + 3% + MRP + 1.5%
IP3 = 4.5%
Let inflation after Year 1 be x
IP3 = (3%+x + x)/3 = 4.5%
2x = 14-3
x = 5.5%