Problem 4-18 Determinants of Interest Rates The real risk-free rate is 4%. Inflation is expected to...

Problem 4-18
Determinants of Interest Rates

The real risk-free rate is 4%. Inflation is expected to be 2% this year, 3% next year, and then 5.5% thereafter. The maturity risk premium is estimated to be 0.0007 x (t - 1), where t = number of years to maturity. What is the nominal interest rate on a 7-year Treasury security? Round your answer to two decimal places.

_____%

Solutions

Expert Solution

Real Risk-free Rate = 4.00%

Inflation Premium = Average Inflation over 7 years
Inflation Premium = [2.00% + 3.00% + 5 * 5.50%] / 7
Inflation Premium = 32.50% / 7
Inflation Premium = 4.64%

Maturity Risk Premium = 0.0007 * (t - 1), t is number of years to maturity
Maturity Risk Premium = 0.0007 * (7 - 1)
Maturity Risk Premium = 0.0042 or 0.42%

Nominal Interest Rate = Real Risk-free Rate + Inflation Premium + Maturity Risk Premium
Nominal Interest Rate = 4.00% + 4.64% + 0.42%
Nominal Interest Rate = 9.06%

jeff jeffy answered 1 year ago

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