Question

1- Due to a recession, expected inflation this year is only 4.25%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 4.25%. Assume that the expectations theory holds and the real risk-free rate (r*) is 3.5%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 2.0%, what inflation rate is expected after Year 1? Round your answer to two decimal places.

2- The real risk-free rate is 3.5% and inflation is expected to be 2.25% for the next 2 years. A 2-year Treasury security yields 5.95%. What is the maturity risk premium for the 2-year security? Round your answer to one decimal place.

Answer 1

1.
yield on 3 year=yield on 1 year-inflation for 1 year+average inflation for 3 year

Let inflation expected after Year 1 be x

Given,
yield on 3 year=yield on 1 year+2%
=>-inflation for 1 year+average inflation for 3 year=2%
=>-4.25%+(4.25%+x+x)/3=2%
=>x=((2%+4.25%)*3-4.25%)/2
=>x=7.25%

2.
=yield on 2 year-real risk free rate-inflation
=5.95%-3.5%-2.25%
=0.20%