In: Finance
Problem 4-23
Determinants of Interest Rates
Suppose you and most other investors expect the inflation rate to be 8% next year, to fall to 5% during the following year, and then to remain at a rate of 3% thereafter. Assume that the real risk-free rate, r*, will remain at 2% and that maturity risk premiums on Treasury securities rise from zero on very short-term securities (those that mature in a few days) to a level of 0.2 percentage points for 1-year securities. Furthermore, maturity risk premiums increase 0.2 percentage points for each year to maturity, up to a limit of 1.0 percentage point on 5-year or longer-term T-notes and T-bonds.
Calculate the interest rate on 1-year Treasury securities.
Round your answer to two decimal places.
%
Calculate the interest rate on 2-year Treasury securities. Round
your answer to two decimal places.
%
Calculate the interest rate on 3-year Treasury securities. Round
your answer to two decimal places.
%
Calculate the interest rate on 4-year Treasury securities. Round
your answer to two decimal places.
%
Calculate the interest rate on 5-year Treasury securities. Round
your answer to two decimal places.
%
Calculate the interest rate on 10-year Treasury securities. Round
your answer to two decimal places.
%
Calculate the interest rate on 20-year Treasury securities. Round
your answer to two decimal places.
%
GIVEN:
Risk free rate r*= 2%
Inflation rate for yr 1 = 8%
Inflation rate for yr 2= 5%
Inflation rate for yr 3 and there after = 3%
Maturity risk premium for yr 1 = 0.2%
Maturity risk premium increases every yr by 0.2% up to 1%
Interest rate r = r* + Inflation Premium + Maturity Premium
MATURITY | RISK FREE INTEREST % | INFLATION RATE % | MATURITY RISK PREMIUM % | INTEREST RATE OF BOND % (answer) |
1 | 2 | 8 | 0.2 | 10.2 |
2 | 2 | 5 | 0.4 | 7.4 |
3 | 2 | 3 | 0.6 | 5.6 |
4 | 2 | 3 | 0.8 | 5.8 |
5 | 2 | 3 | 1 | 6 |
10 | 2 | 3 | 1 | 6 |
20 | 2 | 3 | 1 | 6 |