Kern Corporation's 5-year bonds yield 7.50% and 5-year T-bonds yield 4.30%.The real risk-free rate is r* = 2.5%,the default risk premium for Kern's bonds is DRP = 1.90% versus zero for T-bonds,the liquidity premium on Kern's bonds is LP = 1.3%,and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%,where t = number of years to maturity.What is the inflation premium (IP)on all 5-year bonds?

Question

Kern Corporation's 5-year bonds yield 7.50% and 5-year T-bonds yield 4.30%.The real risk-free rate is r* = 2.5%,the default risk premium for Kern's bonds is DRP = 1.90% versus zero for T-bonds,the liquidity premium on Kern's bonds is LP = 1.3%,and the maturity risk premium for all bonds is found with the formula MRP = (t - 1)  0.1%,where t = number of years to maturity.What is the inflation premium (IP)on all 5-year bonds?

Quizplus · Accepted Answer

The inflation premium can be calculated with the formula IP = Nominal yield - Real risk-free rate - Expected inflation. 
Since we are given the real risk-free rate (r*) and the nominal yield for Kern's bonds (7.50%), we need to find the expected inflation. 
Using the Fisher equation, we can solve for the expected inflation:

Nominal yield = Real risk-free rate + Expected inflation + DRP + LP + MRP

7.50% = 2.5% + Expected inflation + 1.90% + 1.3% + (4-1) 0.1% 
Expected inflation = 1.40%

Therefore, the inflation premium for all 5-year bonds is 1.40%.

Kern Corporation's 5-Year Bonds Yield 7