PART C

Let assume that you are studying the rate of inflation starting January $1^{st},2023.$ The rate of inflation is expected to be $4\%$ throughout $2023.$ However, increased government deficits and renewed vigor in the economy are then expected to push inflation rates higher. In $2024$ the inflation rate is expected to increase to $5\%.$ The rate of inflation continues to increase to $6\%$ in $2025,$ increase to $8\%$ in $2026$ decline to $7\%$ in $2027.$

real risk$-$free $(k^{**}),$ is expected to be at $()$ the years.

Maturity risk premiums on treasury securities rise from zero on very short$-$term bonds $($those that mature in a few days$)$ to a level of $1\%$ point for $1-$year securities$.$ Investors also demand a $1\%$ premium for each year until maturity for any debt, with a maximum value of $10\%.$

From the above information you are required to:

a$.$ Compute the interest rate for a one, two, three, four, and five$-$year bond.

$(8$ marks$)$

b$.$ If inflation is expected to equal $8\%$ every year after $2027,$ what should be the interest rate for a $10$and $20-$year bond?

$(3$ marks$)$

c$.$ Plot the yield curve for the interest rates you computed in part $($a$)$ and $($b$),$ and explain the relationship between the interest and years.

$(2$ marks$)$

d$.$ Based on the curve $($in part c$),$ what would you do if you were the lender, are you going lend more or less? Explain your answer.

$(1$ marks$)$

e$.$ Assume that you are an investor, based on the increase in interest rate, what would happen to your rate of return. Explain.

$(1$ Marks$)$

$(15$ MARKS$)$