**Unformatted text preview: **During the week ended
March 15, 2002, 3-month T-bills earned a 1.81 percent rate of return. Assuming
an approximate 1 percent real rate of interest, funds suppliers were forecasting a
0.81 percent (annual) rate of inflation (1.81% 1.00%) over the next 3 months.
This expectation was in striking contrast to the expected rate of inflation 17 years
earlier in the week ending May 22, 1981. At that time the 3-month T-bill rate
was 16.60 percent, which meant an expected (annual) inflation rate of 15.60 percent (16.60% 1.00%). The inflationary expectation premium changes over
time in response to many factors, including recent rates, government policies, and
international events.
Figure 6.2 illustrates the movement of the rate of inflation and the risk-free
rate of interest during the period 1978–2001. During this period the two rates
tended to move in a similar fashion. Between 1978 and the early 1980s, inflation
and interest rates were quite high, peaking at over 13 percent in 1980–1981.
Since 1981 these rates have declined to levels generally below those in 1978. The
data clearly illustrate the significant impact of inflation on the nominal rate of
interest for the risk-free asset. 4. The risk premium and its effect on the nominal rate of interest are discussed and illustrated in a later part of this
discussion. CHAPTER 6 Interest Rates and Bond Valuation 267 FIGURE 6.2
15
Annual Rate (%) Impact of Inflation
Relationship between annual
rate of inflation and 3-month
U.S. Treasury bill average
annual returns, 1978–2001 10
T-billsa
5
Inflationb
1978 1983 1988 1993 1998 2001 Year
a Average annual rate of return on 3-month U.S. Treasury bills.
b Annual pecentage change in the consumer price index. Source: Data from selected Federal Reserve Bulletins. term structure
of interest rates
The relationship between the
interest rate or rate of return and
the time to maturity.
yield to maturity
Annual rate of return earned on a
debt security purchased on a
given day and held to maturity.
yield curve
A graph of the relationship
between the debt’s remaining
time to maturity (x axis) and its
yield to maturity (y axis); it
shows the pattern of ann...

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