For every question please write down each main step before y

For every question, please write down each main step before you obtain the final answer. Correct final answer with incorrect related work (calculation) or without any work may receive 0 point. On the contrary, incorrect final answer with correct related work (calculation) will receive partial credits.

Question 2 – Inflation Premium [4 points]: Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 10 percent, and 9 percent, respectively. What is the inflation premium on a three-year bond (i.e., IP₃), and what is the inflation premium on a five-year bond (i.e., IP₅)?

Solution

Inflation premium = average of the expected inflation over the life of the bond

So,

IP3 (inflation premium for 3 year bond) = (4%+7%+10%)/3

IP3 (inflation premium for 3 year bond) = 7%

IP5 (inflation premium for 5 year bond) = (4%+7%+10%+10% + 9%)/5

IP5 (inflation premium for 5 year bond) = 8%