Assume that the real risk-free rate of return, k*, is 2%, and it will remain at...

 

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Assume that the real risk-free rate of return, k*, is 2%, 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: Inflation Rate (%) 6 7 8 Year 2021 2022 2023 a. Compute the interest rate for a one-, two-, three-year bond. (6 marks) b. If inflation rate is expected to be equal 10% every year after year 2023, what should be the interest rate for a five- and 10-year bond? (6 marks) (4 marks) d. Based on the curve (in part c), what would you do if you were the borrower, are you going to borrow more? Explain your answer. (4 marks) c. Plot the yield curve for the interest rates you computed in part (a) and (b). Assume that the real risk-free rate of return, k*, is 2%, 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: Inflation Rate (%) 6 7 8 Year 2021 2022 2023 a. Compute the interest rate for a one-, two-, three-year bond. (6 marks) b. If inflation rate is expected to be equal 10% every year after year 2023, what should be the interest rate for a five- and 10-year bond? (6 marks) (4 marks) d. Based on the curve (in part c), what would you do if you were the borrower, are you going to borrow more? Explain your answer. (4 marks) c. Plot the yield curve for the interest rates you computed in part (a) and (b).

Answer rating: 100% (QA)

a To compute the interest rates for one two and threeyear bonds we need to add the real riskfree rat... View the full answer