Question

I. The nominal interest rate is 7%. If the expected inflation is 1% and the risk...

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?

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Answer #1

I)

Nominal rate of interest = Real risk free rate + Inflation premium + default risk premium + liquidity premium + maturity risk premium

Risk free rate = Nominal interest rate - expected inflation - Risk premium

Risk free rate = 7% - 1% - 2%

Risk free rate = 4%

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II)

Expected inflation = Nominal risk free rate - Real rate of interest - Risk premium

Expected inflation = 7% - 3% - 2%

Expected inflation = 2%

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