Question

What would be the interest rate on a 10-year Treasury bond, given the following information? kpr = 2% MR = 0.1% for a 1-year loan, increasing by 0.1% each additional year. LR = 0.5% DR= 0 for a 1-year loan, 0.1% for a 2-year loan, increasing by 0.1% for each additional year. Expected inflation rates: Year 1 = 3.0% Year 2 = 4.0% Year 3 and thereafter: 5.0% 6.7% 9.1% 7.7% 8.9%

Answer 1

r* =	2%
YEAR	INFLATION	LP	MRP	DRP	AVERAGE INFLATION PER YEAR(IP)		K = r*+IP+LP+MRP+DRP
1	3.00%	0.50%	0.10%	0.00%	3.00%	3.00%	5.60%
2	4.00%	0.50%	0.20%	0.10%	(3%+4%)/2=	3.50%	6.30%
3	5.00%	0.50%	0.30%	0.20%	(3%+4%+5%)/3=	4.00%	7.00%
4	6.70%	0.50%	0.40%	0.30%	(3%+4%+5%+6.7%)/4=	4.68%	7.88%
5	9.10%	0.50%	0.50%	0.40%	(3%+4%+5%+6.7%+9.1%)/5=	5.56%	8.96%
6	7.70%	0.50%	0.60%	0.50%	(3%+4%+5%+6.7%+9.1%+7.7%)/6=	5.92%	9.52%
7	8.90%	0.50%	0.70%	0.60%	(3%+4%+5%+6.7%+9.1%+7.7%+8.9)/7=	6.34%	10.14%
8	8.90%	0.50%	0.80%	0.70%	(3%+4%+5%+6.7%+9.1%+7.7%+(8.9x2))/8=	6.66%	10.66%
9	8.90%	0.50%	0.90%	0.80%	(3%+4%+5%+6.7%+9.1%+7.7%+(8.9x3))/9=	6.91%	11.11%
10	8.90%	0.50%	1.00%	0.90%	(3%+4%+5%+6.7%+9.1%+7.7%+(8.9x4))/10=	7.11%	11.51%
	Answer is 11.51%