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Home > Business & Careers > Finance   »   Inflation and interest rates

 
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Old Jun 27, 2007, 04:59 PM
wild one
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Inflation and interest rates

Sorry. It's a long question but I'm stumped. I think I have a and b figured out but I'm not certain and I'm stuck on the rest. Please help.

First the background info: In the late 1980, the US Commerce Department released new data showing inflation was 15%. At that time the prime rate of interest was 21%. However, many investors expected the new administration to be more effective in controlling inflation than the previous administration had been. Moreover, many observers believed that the extremely high interest rates and generally tight credit would lead to a recession, which in turn, would lead to a decline in inflation and interest rates. Assume that at the beginning of 1981, the expected inflation rate for 1981 was 13%; for 1982, 9%; for 1983, 7%; and for 1984 and thereafter, 6%.

a. What was the average expected inflation rate over the 5-year period 1981-1985?
b. What average nominal interest rate would (over the 5-year period) be expected to produce a 2% real risk-free return on 5-year treasury securities?
c. Assuming a real risk-free rate of 2% and a maturity risk premium that equals 0.1 X (t)%, where t is the number of years to maturity, estimate the interest rate in January 1981on bonds that mature in 1, 2, 5, 10 and 20 years. Draw the yield curve.
d. If investors in early 1981 expected the inflation rate for every future year was 10%, what would the yield curve have looked like?

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