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Inflation Premium of Interest Rates

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Little Monsters Inc, borrowed $1,000,000 for two years from NorthernBank Inc, at an 11.5% interest rate. The current risk free rate is 2% and Little Monsters financial condition warrants a default risk premium of 3% and a liquidity risk premium of 2%. The maturity risk premium for a two year loan is 1%, and inflation is expected to be 3% next year. What does this information imply about the rate of inflation in the second year?

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Inflation premium is determined in this solution.

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If inflation were expected to remain constant at 3% over the life of the loan, the interest rate on the two-year loan would be 11%. Since ...

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