Problem 6-16. Inflation cross product An analyst is evaluating securities in a d

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 19.15%. If the real risk-free rate is 5.75%, 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 box titled, "The Links Between Expected Inflation and Interest Rates: A Closer Look.")

Explanation / Answer

at zero maturity, default, liquidity risk;

(1+yield%) = (1+real risk free rate)*(1+inflation rate)

Inflation rate = (1+yield%)/(1+real risk free rate) -1
= (1+19.15%)/(1+5.75%) - 1
= 12.67%

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