Assume that the real risk-free rate of return, r*, is 1%, and it will remain at...

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Assume that the real risk-free rate of return, r*, is 1%, and itwill remain at that level far into the future. Also assume thatmaturity risk premium on Treasury bonds increase from zero forbonds that mature in one year or less to a maximum of 2%, and MRPincreases by 0.2% for each year to maturity that is greater thanone year – that is, MRP equals 0.2% for two-year bond, 0.4% for athree-year bond, and so forth. Following are the expected inflationrates for the next five years:
Year
Inflation Rate
2018
1%
2019
1.5%
2020
2%
2021
2.5%
Compute the interest rate for 1, 2, 3, and 4-year bond.
If inflation is expected to equal 3% every year after 2021, whatshould the interest rate be for 5- through 20-year bond?
Draw a graph of the yield curve.

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3.8 Ratings (711 Votes)

1 Interest rate for 1 2 3 and 4year bondBonds maturing yearRisk free rateMaturity risk premiunInflation rateInterest rate2018 1 year See Answer

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Assume that the real risk-free rate of return, r*, is 1%, and itwill remain at that level far into the future. Also assume thatmaturity risk premium on Treasury bonds increase from zero forbonds that mature in one year or less to a maximum of 2%, and MRPincreases by 0.2% for each year to maturity that is greater thanone year – that is, MRP equals 0.2% for two-year bond, 0.4% for athree-year bond, and so forth. Following are the expected inflationrates for the next five years:YearInflation Rate20181%20191.5%20202%20212.5%Compute the interest rate for 1, 2, 3, and 4-year bond.If inflation is expected to equal 3% every year after 2021, whatshould the interest rate be for 5- through 20-year bond?Draw a graph of the yield curve.