Question

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

b. Suppose that there is an increase in expected inflation rate from 3 percent to 6 percent. Given that the after-tax expected real interest rate remains unchanged at 2 percent and the tax rate is 30 percent, find the original and the new nominal interest rates.

c. Suggest ONE way in which investors can reduce/avoid the risk of unexpected inflation.

Answer #1

1. Realised real interest rate in the rate of interest realised after taking out the effects of inflation. Put it simply Real Interest rate = Nominal Interest rate - Inflation.

Change in expected inflation do not affect the Realised real interest rate as it used the actual rate of inflation into its calculation which is different than the expected rate of inflation.

2. Before tax Real rate = 2/0.7=> 2.857%

Original Nominal Interest rate = 2.857*(1+0.03) => 2.942%

New Nominal Interest rate = 2.857*(1+0.06) => 3.028%

3. Buying TIPS (Treasury Inflation Protected Securities) assures investors to avoid the risk of unexpected inflation as returns and principal are inflation adjusted. Therefore TIPS allowas one to secure a fixed real rate of return.

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Suppose that the nominal rate of interest is 5% and the expected
rate of inflation is 2%. Whats is the expected real rate of
interest according to Fisher? Calculate the after-tax expected real
rate of assuming a 30% marginal tax rate. If inflation expectations
increase by 2%, what will be the new nominal rate according to
fisher? According to darby/feldstein? What should happen to bond
prices and stock prices if the expected rate of inflation
increase

Distinguish between the nominal rate and the real rate of
interest. How does inflation affect the real, ex post (after the
fact) rate of return to investors?

If the real interest rate was large during the last year, then
a. inflation is expected to exceed the nominal interest rate in the
future. b. inflation is expected to be less than the nominal
interest rate in the future. c. actual inflation was less than the
nominal interest rate. d. actual inflation was greater than the
nominal interest rate.

An increase in the rate of inflation will:(multiple choice)
increase both the real and the nominal rate of interest.
increase the nominal interest rate but will not affect the real
interest rate.
increase the nominal interest rate while lowering the real
interest rate.
decrease both the real and the nominal rate of interest.
increase the real interest rate but not affect the nominal
interest rate.

I. The nominal interest rate is 7%. If the
expected inflation is 1% and the risk premium equals 2%, then what
does the risk-free rate equal?
II. The nominal risk-free rate is 7% and the
real rate of interest is 3%; then what is the expected inflation is
expected to be?

PLEASE SHOW ON EXCEL
The real risk-free rate of interest is 4%. Inflation is expected
to be 2% this year and 4% during each of the next 2 years. Assume
that the maturity risk premium is zero. What is the yield on 2-year
Treasury securities? What is the yield on 3-year Treasury
securities?
I can do this by hand, but I am wondering the easiest way to do
it on excel. Should I use nominal function? Thanks!

Determinants of Interest Rates
The real risk-free rate is 3%. Inflation is expected to be 2%
this year, 4% next year, and then 4% thereafter. The maturity risk
premium is estimated to be 0.0003 x (t - 1), where t = number of
years to maturity. What is the nominal interest rate on a 7-year
Treasury security? Do not round intermediate calculations. Round
your answer to two decimal places.
%

Calculating Interest rates
The real risk-free (r*) is 2.8% and is expected to remain
constant. Inflation is expected to be 7% per year for each of the
next three years and 6% thereafter.
The maturity risk premium (MRP) is determined from the formula:
0.1(t-1)%, where t is the security's maturity. The liquidity
premiums (LP) on all BTR Warehousing's bonds is 1.05%. The
following table shows the current relationship between bond ratings
and default risk premiums (DRP):
Rating
Default Risk Premium...

An increase in the rate of inflation will leave real and nominal
rates unchanged in the long run. True or false? Use IS and LM
curves to explain your answer.

Suppose that the nominal rate of interest is 5% and the current
expected rate of inflation is 2%. If the expected rate of inflation
were to increase by 5% (to a new level of 7%) the nominal rate
would rise to _____ according to the fisher effect and ______
according to the Darby/Feldstein effect. (for the Darby)/Feldstein
effect assume a marginal tax rate of 40%)
a) 6%; 8%
b) 10%;10%
c) 10%;13.33%
d)12%;15.33%

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