Assume the real rate of interest on 1-year, 10-year, and 30-year bonds is 3%. Also assume the rate of inflation is expected to be 3% for the coming year. Considering only an inflation premium, construct an example showing how an expected increase in the rate of inflation leads to an upward sloping term structure via the Fisher effect. Then, explain how the addition of interest rate risk will affect your results.

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Zybrea Knight · Accepted Answer

Final Answer : The student is expected to generate three nominal rates, each based on an increasing level of inflation, beginning with a one-year nominal rate of 6.09%. The result will be an upward sloping term structure of interest rates. Adding interest rate risk to the mix will increase the yields on the 10 and 30-year bonds, increasing the slope of the term structure.

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