Suppose the inflation rate is expected to be 6.6% next year, 4.6% the following

Question

Suppose the inflation rate is expected to be 6.6% next year, 4.6% the following year, and 3.05% thereafter. Assume that the real risk-free rate, r*, will remain at 2.45% and that maturity risk premiums on Treasury securities rise from zero on very short-term bonds (those that mature in a few days) to 0.2% for 1-year securities. Furthermore, maturity risk premiums increase 0.2% for each year to maturity, up to a limit of 1.0% on 5-year or longer-term T-bonds.

a. Calculate the interest rate on 1-year Treasury securities. Round your answer to two decimal places.
%

b. Calculate the interest rate on 2-year Treasury securities. Round your answer to two decimal places.
%

c. Calculate the interest rate on 3-year Treasury securities. Round your answer to two decimal places.
%

d. Calculate the interest rate on 4-year Treasury securities. Round your answer to two decimal places.
%

e. Calculate the interest rate on 5-year Treasury securities. Round your answer to two decimal places.
%

f. Calculate the interest rate on 10-year Treasury securities. Round your answer to two decimal places.
%

g. Calculate the interest rate on 20-year Treasury securities. Round your answer to two decimal places.

Explanation / Answer

Are we using cross products for inflation? Most intro finance classes do not so I won't.
We do: inflation + risk free rate + MRP
1 year: 6.6%+2.45%+0.2%=9.25%
2 year: (6.6+4.6)/2+2.45+0.2*2=8.45%
3 year: (6.6+4.6+3.05)/3+2.45+0.2*3=7.8%
4 year:(6.6+4.6+3.05*(2))/4+2.45+0.2*4=7.57%
5 year: (6.6+4.6+3.05*(3))/5+2.45+0.2*5=7.52%
10 year: (6.6+4.6+3.05*(8))/10+2.45+0.2*5=7.01%
20 year: (6.6+4.6+3.05*(18))/20+2.45+0.2*5=6.755%

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