6. Inflation is anticipated to be 1% over the next year, 2% in year 2, and then

Question

6. Inflation is anticipated to be 1% over the next year, 2% in year 2, and then level off at 3% indefinitely. If the real interest is 2%, the default risk premium is 1% and maturity risk premium is .02%(t). What would be the interest rate on a 7 year T-bond and a 7 year corporate bond? 6. Inflation is anticipated to be 1% over the next year, 2% in year 2, and then level off at 3% indefinitely. If the real interest is 2%, the default risk premium is 1% and maturity risk premium is .02%(t). What would be the interest rate on a 7 year T-bond and a 7 year corporate bond?

Explanation / Answer

Interest rate on 7 year T bond:

=2% + 1% + ((1 + 0.02%*7)^(1/7)-1) + (((1+0.01)*(1+0.02)*(1 + 0.03)^5)^(1/7)) - 1

= 5.59%

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