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For many reasons the Egyptian economy has faced many difficulties in recent years. Prior to recent reforms, the Egyptian inflation rate, according to the IMF

For many reasons the Egyptian economy has faced many difficulties in recent years. Prior to recent reforms, the Egyptian inflation rate, according to the IMF was running at an annual interest rate of 15%. At the time the base lending rate (prime rate as charged to the best borrowers) was 21%. With the new Reserve Bank Governor Tarek Amer in 2015, it was hoped that control over inflation would be improved although it was feared by some investors that higher rates and tighter credit would to economic contraction. Given the following historic data, please answer the following questions.

YEAR

INFLATION RATE

2014

13%

2015

9%

2016

7%

2017

6%

2018

6%

a. What was the average expected inflation rate over the five (5) year period between 2014 and 2018? (10 marks)

b. If you purchased 5-year Treasury Bonds issued by the Central Bank of Egypt in 2014, what nominal yield should have been offered in order to provide a 2% real risk-free rate of return assuming a maturity premium of 2.93%. Explain your results. (15 marks)

c. If the real risk-free rate on the shortest Egyptian government securities were 2% in 2014 and the maturity premium for one year were 2% and increases at a compound annual rate of 10%, what would have been the interest rate in January 2014 on government bonds that mature in 2, 5, 10 and 20 years. Using this data, plot these results on a yield curve. Under what market sentiment might the maturity premium increase? (15 marks)

d. If before the change of Reserve Bank Governor, investors in early 2014 had expected the inflation rate for every year to be 10% instead of the data shown above, how would the yield curve have shifted? Explain why. (20 marks)

e. If after Year 5, 2019, the Maturity Premium rather than growing at a compound rate as mentioned began to fall by 10% per year, what sort of Yield Curve would we observe and what might indicate on the outlook for the Egyptian economy? (20 marks)

f. More generally, explain the factors affect the Yield Curve and the extent to which a Pure Expectations theory may not hold and why.

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