QUESTION 1

Let say today is January 1, 2018. The rate of inflation is expected to be 4% throughout 2018. However, increased government deficits and renewed vigour in the economy are then expected to push inflation rates higher. Investors expect the inflation rate to be 5% in 2019, 6% in 2020, and 7% in 2021. The real risk-free rate, k* is expected to remain at 2% over the next 5 years. Investors also demand a 0.1% premium for each year until maturity for any debt with a term to maturity greater than 1 year, with a maximum value of 1%.

a.Compute the inflation premium for the year 2021.

b.Compute the market risk-free interest rate for the year 2021

c.Compute the quoted interest rate for the year 2021.

e.Which of the following statements represent the above situations?

1. The shorter the period, no changes in the interest rate
2. The longer the period, the lower will be the interest rate
3. The longer the period, the higher will be the interest rate
4. The shorter the period, the higher will be the interest rate