2. a. If the real interest rate is 5% and the (expected) inflation rate is 0%,...

2. a. If the real interest rate is 5% and the (expected) inflation rate is 0%, what will be the price of a risk free bond that matures in one year with a face value of $500?

b. If the (expected inflation rate increases to 2%, what will the price of this bond be?

c. Show this change (from a to b) in a graph of the bond market with the quantity of bonds on the horizontal axis and the price of the bonds on the vertical.

--- I know how to solve A and B. I need to help C. ----

Solutions

Expert Solution

Bond price is obtained by using nominal interest rate, where

Nominal interest rate = Real interest rate + Inflation rate

When Inflation rate > 0, Nominal interest rate > Real interest rate, and the higher the inflation rate, the higher the nominal rate. So, nominal interest rate is higher in part (b) than in part (a).

When nominal interest rate (prevailing in market) increases (therefore making the bond coupon rate relatively lower), demand for bond falls. Demand curve shifts leftward, decreasing both price and quantity of bonds.

In following graph, (P) and quantity (Q) of bonds are depicted along vertical and horizontal axes. D0 & S0 are initial demand and supply curves intersecting at point A with initial equilibrium price P0 and quantity Q0. When bond demand decreases, D0 shifts left to D1, intersecting S0 at point B with lower bond price P1 and lower quantity of bonds Q1.

Rahul Sunny answered 1 year ago

Next > < Previous

Related Solutions

5. If the annual real rate of interest is 5% and the expected inflation rate is...

5. If the annual real rate of interest is 5% and the expected inflation rate is 4%, the nominal rate of interest would be approximately A. 1%. B. 9%. C. 20%. D. 15%. E. 7%. 6. If the annual real rate of interest is 2.5% and the expected inflation rate is 3.7%, the nominal rate of interest would be approximately A. 3.7%. Page | 2 B. 6.2%. C. 2.5%. D. −1.2%. E. 4.3%. 7. You purchased a share of stock...

If the nominal interest rate is 3.25% and expected inflation is 2%, what is the real...

If the nominal interest rate is 3.25% and expected inflation is 2%, what is the real interest rate? Calculate it using the Fisher Effect and the shortened equation.

The real risk-free rate of interest is 3.1%. Inflation is expected to be 5% this year and...

The real risk-free rate of interest is 3.1%. Inflation is expected to be 5% this year and 6% during the next 2 years. Assume that the maturity risk premiums is zero. What is the yield on 1-year treasury securities? Write your answer as a percent (do not type the % character - if your answer is 8.8% write 8.8 in the answer).

The interest rate is 10%. The inflation rate is 5% and the expected inflation rate is...

The interest rate is 10%. The inflation rate is 5% and the expected inflation rate is 10%. The actual real interest rate is: less than or equal to -5% greater than -5% but less than or equal to 0% greater than 0% but less than or equal to 5% greater than 5% but less than or equal to 10% greater than 10%

If the real rate of interest is 2.1% and the expected inflation rate is 3.4%, then...

If the real rate of interest is 2.1% and the expected inflation rate is 3.4%, then what would be nominal interest rate? Select one: a. 5% b. 6% c. 5.57%

The real risk-free rate of interest is 3%. Inflation is expected to be 2% this year...

The real risk-free rate of interest is 3%. Inflation is expected to be 2% this year and 3% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? (If financial calculator is used show those computations and show ALL work)

EXPECTED INTEREST RATE The real risk-free rate is 2.55%. Inflation is expected to be 2.75% this...

EXPECTED INTEREST RATE The real risk-free rate is 2.55%. Inflation is expected to be 2.75% this year, 4.25% next year, and 3.15% thereafter. The maturity risk premium is estimated to be 0.05 × (t - 1)%, where t = number of years to maturity. What is the yield on a 7-year Treasury note? Do not round your intermediate calculations. Round your answer to two decimal places. %

The nominal rate of interest is 7% and the real rate of interest is 3%. What is the expected inflation rate?

If the nominal rate of interest is 13.02% and the real rate of interest is 8.01%, what is the expected rate of inflation?

a) What is realized real interest rate? Can a change in expected inflation rate affect the...

a) What is realized real interest rate? Can a change in expected inflation rate affect the realized real interest rate? Explain.

Subjects