# Expected inflation

A 5-year corporate bond has an 8 percent yield. A 10-year corporate bond has a 9 percent yield. The two bonds have the same default risk premium and liquidity premium. The real risk-free rate, r*, is expected to remain constant at 3 percent. Inflation is expected to be 3 percent a year for the next five years. After five years, inflation is expected to be constant at some rate, X, which may or may not be 3 percent. The maturity risk premium equals 0.1(t - 1)%, where t equals time until the bond's maturity. In other words, the maturity risk premium on the five-year bond is 0.4 percent or 0.004.

Showing the computation what is the market's expectation today of the average level of inflation for Years 6 - 10, i.e., what is X?

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#### Solution Preview

A 5-year corporate bond has an 8 percent yield. A 10-year corporate bond has a 9 percent yield. The two bonds have the same default risk premium and liquidity premium. The real risk-free rate, r*, is expected to remain constant at 3 percent. Inflation is expected to be 3 percent a year for the next five years. After five years, inflation is expected to be constant at some rate, X, which may or ...

#### Solution Summary

The solution calculates market's expectation today of the average level of inflation for Years 6 - 10.