**Suppose the inflation rate is expected to be 2% next year, 3% the following year, and…**

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## Question “Suppose the inflation rate is expected to be 2% next year, 3% the following year, and…”

Suppose the inflation rate is expected to be 2% next year, 3% the

following year, and 5% thereafter. Assume that the real risk free

rate will remain constant at 1% and that MRP = (0.25x(t-1))% where

t is the number of years to maturity. The default risk premium on 5

year corporate bonds is 0.75% and the liquidity premium on 5 year

corporate bonds is 0.25%.

following year, and 5% thereafter. Assume that the real risk free

rate will remain constant at 1% and that MRP = (0.25x(t-1))% where

t is the number of years to maturity. The default risk premium on 5

year corporate bonds is 0.75% and the liquidity premium on 5 year

corporate bonds is 0.25%.

a. Calculate the interest rate on a 5 year treasury

security.

security.

b. Calculate the interest rate on a 5 year security.

## Answer

Inflation rate for five years = [2% + 33% + (5%* 3)]/5 = 20%/5 = 4%

a). 5-year T-Sec. Yield = Real Risk-Free Rate + Inflation rate + MRP

= 4% + 1% + [0.25 * (5 – 1)%]

= 5% + 1% = 6%

b). 5-year Security Yield = Real Risk Free Rate + Inflation rate + MRP + DRP+ LP

= 4% + 1% + [0.25 * (5 – 1)%] + 0.75% + 0.25%

= 6% + 1% = 7%

## Conclusion

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