2. Inflation is expected to be 3 percent over the next year. You desire an annua

Question

2. Inflation is expected to be 3 percent over the next year. You desire an annual real rate of return of 2,5 percent on your investments.
a. What nominal rate of interest would have to be offered on a one-year treasury security for you to consider making an investment?


b. A one-year corporate debt security is being offered at 2 percentage points over the one year Treasury security rate that meets your requirement in (a). What would be the nominal interest rate on the corporate security?

Explanation / Answer

a) nominal rate, k = (1+r)(1+ i) -1 (r is real rate= 2.5% = 0.025 and i is inflation= 3% = 0.03) => k = (1+0.0250)*(1+0.03) -1 = 0.05575 = 5.575 % (ANSWER) b) for corporate security, r= 2.5+2 = 4.5% = 0.045 i = 35 = 0.03 so, k = (1+0.045)*(1+0.03) -1 = 0.07635 = 7.635% (ANSWER)

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