# Question: Assume that the real risk free rate of return r is

Assume that the real risk-free rate of return, r*, is 3 percent and it will remain at that level far into the future. Also assume that maturity risk premiums on Treasury bonds increase from 0 percent for bonds that mature in one year or less to a maximum of 2 percent, and MRP increases by 0.2 percent for each year to maturity that is greater than one year—that is, MRP equals 0.2 percent for a two-year bond, 0.4 percent for a three-year bond, and so forth. Following are the expected inflation rates for the next five years:

Year Inflation Rate

1 .......... 3.0%

2 .......... 5.0

3 .......... 4.0

4 .......... 8.0

5 .......... 3.0

a. What is the average expected inflation rate for one-, two-, three-, four-, and five-year bonds?

b. What should be the MRP for one-, two-, three-, four-, and five-year bonds?

c. Compute the interest rate for one-, two-, three-, four-, and five-year bonds.

d. If inflation is expected to equal 2 percent every year after Year 5, what should be the interest rate for 10-and 20-year bonds?

e. Plot the yield curve for the interest rates you computed in parts (c) and (d).

Year Inflation Rate

1 .......... 3.0%

2 .......... 5.0

3 .......... 4.0

4 .......... 8.0

5 .......... 3.0

a. What is the average expected inflation rate for one-, two-, three-, four-, and five-year bonds?

b. What should be the MRP for one-, two-, three-, four-, and five-year bonds?

c. Compute the interest rate for one-, two-, three-, four-, and five-year bonds.

d. If inflation is expected to equal 2 percent every year after Year 5, what should be the interest rate for 10-and 20-year bonds?

e. Plot the yield curve for the interest rates you computed in parts (c) and (d).

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