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Let say today is January 1, 2018. The rate of inflation is expected to be 4% throughout 2018. However, increased government deficits and renewed intensity in the economy are then expected to push inflation rates higher. Investors expect the inflation rate to be 5% in 2019, 6% in 2020, and 7% in 2021. The real risk-free rate, k* is expected to remain at 2% over the next 5 years. Investors also demand a 0.1% premium for each year until maturity for any debt with a term to maturity greater than 1 year, with a maximum value of 1%.
From the above information, answer the following question.
a. Compute the inflation premium for the year 2021.
b. Compute the market risk-free interest rate for the year 2021.
c. Compute the quoted interest rate for the year 2021.
d. The above situation represents "the longer the period, the lower will be the interest rate". Do you agree with this statement? Explain your answer.
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