Reference no: EM133074770

Assume that the real risk-free rate of return, k*, is 3%, and it will remain at that level far into the future. Also assume that maturity risk premiums (MRP) increase from zero for bonds that mature in one year or less to a maximum of 1%, and MRP increases by 0.2% for each year to maturity that is greater than one year-that is, MRP equals 0.2% for two-year bond, 0.4% for a three-year bond, and so forth. Following are the expected inflation rates for the next five years:

Year Inflation Rate (%)

2017 3
2018 4
2019 5
2020 6
2021 7

From the above information you are required to answer the following questions:

a. Compute the interest rate for a one-, two-, three-, four-, and five-year bond.

b. If inflation rate is expected to be equal 7% every year after 2021, what should be the interest rate for a 10- and 20-year bond?

c. Plot the yield curve for the interest rates you computed in part [a] and [b].

d. Based on the curve (in part c), what would you do if you are the lender? Are going to lend more? Or less? Explain your answer.