A firm has outstanding one set of bonds that will mature in 5 years, and a 2nd set that will mature in 10 years. For the next five years, you expect inflation to average 0.5% per year. You also believe that the risk level of the bond in the next five years justifies a 1.5% ‘default risk premium’ above the rate on risk-free government bonds, which currently yield 3%.

Next, suppose that you believe that inflation will rise in years five through 10 to 1.5% annually. You also think that the economy will deteriorate and that the DRP will increase by 2% annually.

(a) What is the real risk-free rate over the next five years?

(b) What should be the interest rate for the firm’s bonds that mature in 5 years?

(c) In five years from now, what annual interest rate should apply on the bonds that will mature in 10 years (five years from then)?

(d) Assuming the ‘Pure expectations’ theory is true, what should be the current interest rate on the bonds that will mature in 10 years?