How do investors deal with inflation when they determine interest rates in the financial markets? Does the interest rate on a T-bond include a default risk premium? Explain.

Financial markets

Write out an equation for the nominal interest rate on any security.

Distinguish between the real risk-free rate of interest, r*, and the nominal, or quoted, risk-free rate of interest, r RF.

How do investors deal with inflation when they determine interest rates in the financial markets?

Does the interest rate on a T-bond include a default risk premium? Explain.

Distinguish between liquid and illiquid assets, and list some assets that are liquid and some that are illiquid.

Briefly explain the following statement: “Although long-term bonds are heavily exposed to interest rate risk, short-term T-bills are heavily exposed to reinvestment rate risk. The maturity risk premium reflects the net effects of these two opposing forces.” Assume that the real risk-free rate is r* 2% and the average expected inflation rate is 3 percent for each future year. The DRP and LP for Bond X are each 1 percent, and the applicable MRP is 2 percent. What is Bond X’s interest rate? Is Bond X (1) a Treasury bond or a corporate bond and (2) more likely to have a 3-month or a 20-year maturity?