Let assume that you are studying the rate of inflation starting January 1st ,2023. The rate of inflation is expected to be 4% throughout 2023. In 2024 the inflation rate is expected to increase to 5%. This increase is due to an increase in government deficits. The rate of inflation continues to increase to 6% in 2025, increase to 8% in 2026 decline to 7% in 2027. Inflation is expected to be equal at 8% every year after 2027. real risk-free (k*), is expected to be at 2.7% through the years. Maturity risk premiums on treasury securities rise from zero on very short-term bonds (those that mature in a few days) to a level of 0.2% point for 1-year securities. Furthermore, maturity risk premiums increase 0.2% point for each year to maturity, up to a limit of 1.0% point of 5-year or longer-term T-bonds.

From the above information you are required to:

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

b. If inflation is expected to equal 8% every year after 2022, what should be the interest rate for a 10- and 20-year bond? 

c. Plot the yield curve for the interest rates you computed in part (a) and (b), and explain the relationship between the interest and years. 

d. Based on the curve (in part c), what would you do if you were the lender, are you going lend more or less? Explain your answer. 

e. Assume that you are an investor, based on the increase in interest rate, what would happen to your rate of return. Explain. 

Answer rating: 100% (QA)

a To compute the interest rates for one two three four and fiveyear bonds we can use the following formula which accounts for the real riskfree rate k ... View the full answer