Asked by TRISHA MARTINEZ on May 06, 2024
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Assume the real rate of interest on 1-year, 10-year, and 30-year bonds is 3%. Also assume the rate of inflation is expected to be 3% for the coming year. Considering only an inflation premium, construct an example showing how an expected increase in the rate of inflation leads to an upward sloping term structure via the Fisher effect. Then, explain how the addition of interest rate risk will affect your results.
Inflation Premium
The extra yield that investors demand on securities to compensate for the risk of inflation reducing the value of future cash flows.
Fisher Effect
The Fisher Effect describes the relationship between nominal interest rates, real interest rates, and inflation, asserting that the nominal interest rate is equal to the real interest rate plus inflation.
Interest Rate Risk
The risk of changes in interest rates that can adversely affect the value of an investment.
- Understand the concept and implications of the term structure of interest rates.
- Explain the implications of different interest rate environments on bond prices and yields.
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Learning Objectives
- Understand the concept and implications of the term structure of interest rates.
- Explain the implications of different interest rate environments on bond prices and yields.
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