# Inflation and Interest Rates, Real Risk-Free Rate (Math Problem Sample)

Foundations in Finance: #2 Interest Rates and Inflation Solve three problems addressing inflation and interest rates affecting the financial environment, including the real risk-free rate, expected interest rate, detailed risk premium, and ratio analysis.Assignment InstructionsComplete Problems 1–3 on interest rates and inflation affecting financial environment. You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet. In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer. Note the following:You may need an HP 10B II business calculator.You may use Word or Excel, but you will find Excel to be most helpful for creating spreadsheets.If you choose to solve the problems algebraically, be sure to show your computations.If you use a financial calculator, show your input values.If you use an Excel spreadsheet, show your input values and formulas.Problem 1: Real Risk-Free RateCurrent 30-day T-bills are yielding 3.5 percent. Your accountant provided you with these interest rate premiums:IP = 1.5%LP = 0.6%MRP = 1.8%DFP = 2.15%What is the real risk-free rate of return based on this data?Problem 2: Expected Interest RateFor this problem, examine Treasury securities. Considering the following numbers, what would the yield on 3-year Treasury securities be?Real risk-free = 4%.Inflation expected at 1.5% for this year and 2% for the next 2 years.Maturity risk premium = 0.Problem 3: Default Risk PremiumA Treasury bond maturing in 5 years has a yield of 4 percent. A 5-year corporate bond has a yield of 7 percent. Consider that the liquidity premium on the corporate bond is 0.5 percent. If this is so, what is the default risk on the corporate bond?

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Inflation and Interest Rates

Name

Institution

Date

Problem 1: Real Risk-Free Rate

Current 30-day T-bills are yielding 3.5 percent. Your accountant provided you with these interest rate premiums:

IP = 1.5%

LP = 0.6%

MRP = 1.8%

DFP = 2.15%

What is the real risk-free rate of return based on this data?

r = r* + IP

3.5%= r* +1.5%

r*=2%

Problem 2: Expected Interest Rate

For this problem, examine Treasury securities. Considering the following numbers, what would the yield on 3-year Treasury securities be?

Real risk-free = 4%.

Inflation expected at 1.5% for this year and 2% for the next 2 years.

Maturity risk premium = 0.

r = r* + IP + MRP + DRP + LP

r=4 %.+[( 1.5) +2%*2)]/3= 5.83%

The interest rate serves as the starting point when examining the rates of investments, and the interest rate represents the probability th

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