Hatter Enterprises has just borrowed money at 12% for 3 years. The pure rate of interest is 2%. Hatter's default risk premium is 3%, its liquidity risk premium is 3%, and its maturity risk premium is 1%. Inflation is expected to be 3% in the first year of the loan and 4% in the second year. What does the lender expect the inflation rate to be in the loan's third year?

Question

Quizplus · Accepted Answer

The lender expects the inflation rate to be 2% in the loan's third year because the pure rate of interest is 2%, and the inflation rate is expected to be 3% in the first year and 4% in the second year. Therefore, the lender expects the inflation rate to be 2% in the third year.

Hatter Enterprises Has Just Borrowed Money at 12% for 3