Calculating Interest Rates Based on Expectations Theory
Suppose the real risk-free rate (r*) is 2%
Investors demand a 0.1% maturity risk premium per each year remaing until maturity
We will further assume that DRP = 0 and LP = 0 -Treasury bonds have almost-zero default risk and liquidity risk
Finally, yearly inflations are expected to be:
1.0% in Year 1
1.8% in Year 2
2.0% in Year 3
Question: How do we calculate the inflation premium for 1-year bond, 2-year bond, and 3-year bond?
Inflation Premium (IP) for N-year bond is calculated by:
IPN = (INFL1 + INFL2... + INFLN) / N
Let's get the interest rate for a 2-year Treasury Bond:
IP2 = (1.0% + 1.8%) / 2 = 1.4%
MRP2 = 0.1% x 2 = 0.2%
Remember that r* was 2% and DRP = 0 and LP = 0 r = rRF + Risk Premium = (r*+IP)+(DRP+LP+MRP) =(2% + 1.4%) + (0+0+0/2%) =3.6%
In general, when the market interest rate increases, stock prices decrease
Two main reasons:
(1) Increased interest rate makes simple savings more appealing
-Stock market is competing with commercial banking industries To attract investors
-A massive fund outflow from the stock market in response to Rising interest rates will lower stock prices
(2) Discount rate r in the firm value formula increases, as the market rate increases

Homework:
Bonds with higher liquidity will demand lower interest rates in the
Market since they can be easily converted into cash on short notice.
**When faced with a T/F question, if the question has the word
“necessarily”, then it is likely FALSE**
5-3) One year ago, you purchased $1050 worth of stock for $42/share.
During the year, you receive 2 dividend payments of $0.05/share.
The current market value of the stock is $44/share.
What did you earn on your investment?
Capital Gains: 44-42 = 2 | Dividends = 0.05 * 2