Question

1. What is the 3-year inflation premium if expected inflation in year 1 is 6%, expected inflation in year 2 is 7% and expected inflation in year 3 is 8%? (express your answer as a percentage).

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2. The real risk-free rate of interest is 3%. Inflation is expected to be 2% this year and 4% next year. Assume that the maturity risk premium is zero. What is the yield on a 2-year Treasury security? (express your answer as a percentage).

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Thank you in advance!!

Answer 1

1.

Inflation premium on 3 year security=Average of expected inflation=(6%+7%+8%)/3=7%

2.

Yield on 2 year Treasury security=Real risk free rate+Inflation premium+Maturity Risk Premium=Real risk free rate+Average Inflation for 2 years+Maturity Risk Premium=3%+(2%+4%)/2+0=6%