Question

1. Voice River, Inc. , provides media-on-demand services via the Internet. Management has been studying current interest rates. A lender is willing to make a two-year loan to Voice River at a 12 percent annual interest rate. The U. S. Government is currently paying 8 percent annual interest on its two-year securities. A. If the real rate of interest is expected to be 3 percent annually, what is the inflation premium expected at this time

Answer 1

Based on the rate the government is paying for its securities and the rate the lender is willing to make, the inflation premium must be 5%.

What is the inflation premium?

This is the part of the risk free rate that accounts for inflation in an economy.

It can be found as:

= Risk free rate - Real rate

Solving gives:

= 8% - 5%
= 3%

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