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 3% and inflation is expected to be 11% 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 the risk-free rate is 3% and expected inflation rate is 11%, that would result in a total rate of 14%. Then 1/0.14 = 7.143. Therefore, yield of 14.3% is required.

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