An analyst is evaluating securities in a developing nation where the inflation rate is very high. As a result, the analyst has been warned not to ignore the cross-product between the real rate and inflation. A 6-year security with no maturity, default, or liquidity risk has a yield of 16.60%. If the real risk-free rate is 6%, what average rate of inflation is expected in this country over the next 6 years?

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Introduction: The Fisher equation relates the nominal interest rate (the yield of the security), the real interest rate, and the expected inflation rate. The equation is given by: Nominal rate = Real rate + Inflation rate + (Real rate * Inflation rate) We are given the nominal rate and the real rate, and we need to solve for the inflation rate. Nominal rate = 16.60% Real rate = 6% Let's denote the inflation rate as ＂i＂.Conversion to Decimals: First, we express the rates as decimals rather than percentages for calculation purposes. Nominal rate = 0.1660 Real rate = 0.06 Now we can set up the Fisher equation with these values: 0.1660 = 0.06 + i + (0.06 * i)Setting up Fisher Equation: Next, we need to solve for ＂i＂. To do this, we'll combine like terms and then isolate ＂i＂ on one side of the equation. 0.1660 = 0.06 + i + 0.06i 0.1660 = 0.06 + i(1 + 0.06) 0.1660 = 0.06 + 1.06iIsolating Inflation Rate: Now, we subtract 0.06 from both sides to get the terms with ＂i＂ by themselves. 0.1660 - 0.06 = 1.06i 0.1060 = 1.06iSolving for Inflation Rate: To find ＂i＂, we divide both sides by 1.06. i = 0.1060 / 1.06 i ≈ 0.1Final Result: Finally, we convert ＂i＂ back into a percentage to express the average rate of inflation expected in the country over the next 6 years. i ≈ 0.1 * 100% i ≈ 10%

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