Assume that the real risk-free rate of return, k*, is 3%, and it will remain at that level far into the future. Also assume that maturity risk premiums (MRP) increase from zero for bonds that mature in one year or less to a maximum of 1%, and MRP increases by 0.2% for each year to maturity that is greater than one year-that is, MRP equals 0.2% for two-year bond, 0.4% for a three-year bond, and so forth. Following are the expected inflation rates for the next five years:

 

  Year           Inflation Rate (%)

   2017                     3

   2018                     4

   2019                     5

   2020                     6

   2021                     7

 
From the above information you are required to answer the following questions:

a.   Compute the interest rate for a one-, two-, three-, four-, and five-year bond.  

Answer rating: 100% (QA)

ANSWER To compute the interest rate for each bond we need to add the expected inflation r... View the full answer