The expectations theory holds and the real risk-free rate

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1. Bond X is noncallable and has 20 years to maturity, a 9% annual coupon, and a $1,000 par value. Your required return on Bond X is 9%; if you buy it, you plan to hold it for 5 years. You (and the market) have expectations that in 5 years, the yield to maturity on a 15-year bond with similar risk will be 8.5%. How much should you be willing to pay for Bond X today? (Hint: You will need to know how much the bond will be worth at the end of 5 years.) Do not round intermediate calculations. Round your answer to the nearest cent.

2. INFLATION Due to a recession, expected inflation this year is only 3.25%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 3.25%. Assume that the expectations theory holds and the real risk-free rate (r*) is 2%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 2%, what inflation rate is expected after Year 1? Round your answer to two decimal places.

Reference no: EM131987676

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