ImranOmer_37_15663_1_Questions Market Interest Rate.docx - From the Desk of Imran Omer The Determinants of Market Interest Rate Q1 Assume that it is now

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From the Desk of: I mran O mer The Determinants of Market Interest Rate Q1: Assume that it is now January 1, 2002. The rate of inflation is expected to be 4% throughout 2002. However, increased government deficits and renewed vigor in the economy are then expected to push inflation rates higher. Investors expect the inflation rate to be 5% in 2003, 6% in 2004, and 7% in 2005. The real risk-free rate, k*, is expected to remain at 2% over the next 5 years. Assume that no maturity risk premiums are required on bonds with 5 years or less to maturity. The current interest rate on 5-year T-bonds is 8%. a. What is the average expected inflation rate over the next 4 years? b. What should be the prevailing interest rate over the next 4 year T-bonds? c. What is the implied expected inflation rate in 2006, or Year 5, given that Treasury bonds which mature in that year yield 8%? Q2: The real risk free rate of interest is 3%. Inflation expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero.
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