You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 3.55%. Your broker has determined the following information about economic activity and Moore Corporation bonds: Real interest rate = 2.75%
Default risk premium = 1.05%
Liquidity risk premium = 0.50%
Maturity risk premium = 1.85%
What is the inflation premium?

Question

Quizplus · Accepted Answer

The inflation premium can be calculated using the Fisher equation: nominal interest rate = real interest rate + inflation premium. Rearranging the equation, we get inflation premium = nominal interest rate - real interest rate.

Using the information provided, we can calculate the nominal interest rate as follows:

Nominal interest rate = 1-year T-bill rate + default risk premium + liquidity risk premium + maturity risk premium
Nominal interest rate = 3.55% + 1.05% + 0.50% + 1.85%
Nominal interest rate = 7.95%

Therefore, the inflation premium = 7.95% - 2.75% = 5.20%, or 0.80% when rounded to the nearest whole percentage point.

Thus, the correct answer is A.

You Are Considering an Investment in 30-Year Bonds Issued by Moore