ABC Company has a corporate bond with 5 years to maturity. It pays annual coupon

Question

ABC Company has a corporate bond with 5 years to maturity. It pays annual coupons and has a coupon rate of 5% and its current market price is $800 The real risk-free rate is 2% and remains constant over the next 5 years, while the sum of the default risk premium and liquidity premium of the bond is 3%. The formula for the maturity risk premium is 0.4% x (t - 1), Where t = number of years to maturity. What is the average expected inflation over the next five years? (A) 10.32% (B) 8.53% (C) 7.50% (D) 3.72% (E) 2.21%

Explanation / Answer

Coupon rate = (1+ real rate)(1+inflation) - 1

Therefore, 5%=(1+2%)(1+x)-1

I.e. 1.05/1.02-1 = x

X=2.9%

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