Question

Assume that the real interest rate is 2%, the default risk premium is 3%, the liquidity premium is 1%, and the maturity risk premium is 1% per year. Additionally, the expected inflation rate is 2% next year, 5% the year after, and 3% from then on. What are the nominal interest rates for: a) (5 pts) 1-year note? b) (5 pts) 5-year bond? c) (5 pts) Does this produce an inverted yield curve? Why or why not?

Answer 1

Nominal interest rates for

a)1-year note

Nominal interest rate=Real interest rate+Inflation Rate(next Year)+Default risk premium +Liquidity premium+maturity risk premium

2%+2%+3%+1%+1%=

9%

b)5-year bond:

Nominal interest rate=Real interest rate+Av.Inflation Rate(for 5 years)+Default risk premium +Liquidity premium+maturity risk premium

2%+((2%+5%+3%+3%+3%)/5)+3%+1%+1%=

10.2%

c. YES.

As the yield/return required on the 1-year note,ie. with a comparatively shorter duration is higher than the yield/return on 5-year bond that has a longer duration.

As when the yield curve is normal, the short-term securities yield less than the long-term bonds, as the investors are satisfied with lower returns as the tied-up period is short.Higher returns are required only for long-term investments.