Suppose the real risk-free rate, r*, is 2% and investors expect inflation to be

Question

Suppose the real risk-free rate, r*, is 2% and investors expect inflation to be 4% next year, 5% the following year, and 7% per year thereafter. Assume the MRP is zero for Year 1 and increases by 0.1% each year. Compute the quoted, or risk-free, rate of return for Year 8.

Please clearly explain answer

Suppose the real risk-free rate, r*, is 2% and investors expect inflation to be 4% next year, 5% the following year, and 7% per year thereafter. Assume the MRP is zero for Year 1 and increases by 0.1% each year. Compute the quoted, or risk-free, rate of return for Year 8.

Explanation / Answer

We have r = r* + IP + MRP

Where

r = required interest rate

r* = real risk-free rate of interest =2%

IP = inflation premium

MRP = maturity risk premium = 7*0.1% = 0.7%

Avge IP = (4%+5%+5*7%)/7 = 6.29%

at t=1, MRP = 0

t=2, MRP = 0.1

t=3, MPR = (t-1)*0.1% = 0.2%

t=8, MRP = (8-1)*0.1% = 0.7%

So r8 = r* + IP + MRP = 2% + 6.29% + 0.7% = 8.99%

So uoted, or risk-free, rate of return for Year 8 = 8.99%

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.