BM2213

NAME: DATE: SCORE:

Inflation and Interest Rates (30 points: 6 items x 5 points)

Read and analyze the given scenario and provide what is asked. Show your complete solutions.

1. The real risk-free interest rate is 3%, which is expected to remain constant over time. Inflation is expected
to be 2% per year for the next three (3) years and 4% per year for the next five (5) years. The maturity risk
premium equals 0.1 × (𝑡 − 1)%, where t = the bond’s maturity. The default risk premium for a BBB-rated
bond is 1.3%.

a. What is the average expected inflation rate over the next four (4) years?

b. What is the quoted interest rate on a 4-year Treasury bond?

c. What is the quoted interest rate on a 4-year BBB-rated corporate bond with a liquidity premium of
0.5%?

d. What is the quoted interest rate on an 8-year Treasury bond?

e. What is the quoted interest rate on an 8-year BBB-rated corporate bond with a liquidity premium of
0.5%?

f. If the quoted interest rate on a 9-year Treasury bond is 7.3%, what does that imply about expected
inflation in nine (9) years?

GRADING RUBRIC:
CRITERIA POINTS
Complete solution with correct answer 5
Half of the solution is correct. 3
First major step of the solution is correct. 1

06 Performance Task 1 *Property of STI

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