Inflation Cross-Product An analyst is evaluating securities in a developing nati

Question

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 6% and inflation is expected to be 8% 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 200.) Round your answer to two decimal places.

Explanation / Answer

If there is no maturity, default or liquidity risk, we only need to consider inflation risk,

Now this can be calculated in two ways,

If rates are multiplicative then yield will be calculated as (1+0.06)*(1+0.08) - 1 = 1.1448 - 1 = 14.48 %

If rates are additive then yield will be calculated as 0.06 + 0.08 = 14%

Usuallly it is multiplicative and the answer should be 14.48%

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