Assume that the real interest rate is 2%, the default risk premium is 3%, the liquidity...
Assume that the real interest rate is 2%, the default risk premium is 3%, the liquidity premium is 1%, and the maturity risk premium is 1% per year. Additional, the expected inflation rate is 3% next year, 1% the year after, and 10% from then on. What are the nominal interest rates for:
a) 1-year note?
b) 5-year note?
c) does this produce an inverted yield curve? Why or why not?
Please show all work!
Homework Answers
Interest rate for 1 year Note = Real rate+DRP+LP+MRP+ IP
= 2%+3%+1%+1%+ 3%
= 10%
Interest rate for 5 year Note = Real rate+DRP+LP+MRP+ IP
= 2%+3%+1%+1%*5+ (3%+1%+10%*3)/5
= 17.8%
This is not an invesrted yield curve since the rates increase with increase in maturity.
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