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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

EXPECTATIONS THEORY AND INFLATION Suppose 2-year Treasury bonds yield 4.5%, while 1-year bonds yield 3%. r* is 1%, and the maturity risk premium is zero.

  1. a. Using the expectations theory, what is the yield on a 1-ycar bond 1 year from now? Calculate the yield using a geometric average.
  2. b. What is the expected inflation rate in Year 1? Year 2?

a.

Summary Introduction

To identify: The expected yield.

Expectation Theory:

Expectation theory estimates the future interest without taking the maturity risk into consideration. According to the expectation theory, the yield curve of investment totally depends upon the future expectation of investors.

Yield:

Yield is that percentage of the securities at which the return is provided by the company to its investors. Yield can be there in the form of dividend and interest.

Explanation

Solution:

The items required for the computation of the expected interest rate are treasury bond yield for 1-year and treasury bond yield for 2-year.

Given,

The treasury bond yield for 1-year is 4.5% or 0.045

The treasury bond yield for 2-year is 3% or 0.03.

Formula to calculate the expected interest rate derives from the formula of interest rate for the next year,

(1+TreasuryBondYieldfor2-Year)2=((1+TreasuryBondYieldfor1-Year)1(1+ExpectedInterestRate)1)(1+ExpectedInterestRate)1=((1+TreasuryBond <

b.

Summary Introduction

To identify:

The expected inflation rate in year 1 and year 2.

Expected Inflation Rate:

The expected rate, which indicates the general raised price level of goods and services in the market, and currency’s decreased level of purchasing power is called expected inflation rate.

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