The real risk-free rate is expected to remain at 3 percent. Inflation is expecte

Question

The real risk-free rate is expected to remain at 3 percent. Inflation is expected to be 3 percent this year, and 4 percent next year. The maturity risk premium is estimated to be equal to 0.1%(t - 1), where t = the maturity of a bond (in years). All Treasury securities are highly liquid, and therefore have no liquidity premium. Three-year Treasury bonds yield 0.5 percentage points (0.005) more than two-year Treasury bonds (that is, two-year bond yield plus 0.5%). What is the expected level of inflation in Year 3?

Explanation / Answer

step1:

find the yield on 2-year treasury bonds

K2 = k* + IP + MRP

= 3% + (3% + 4%)/2 + 0.1%

= 6.6%

step3:

find yield on 3-year treasury bonds

k3 = 6.6% + 0.5% = 7.1%

step4:

find infation premium
=>

IP3 = k3 - k* - MRP3

= 7.1% - 3% - 0.2%

= 3.9%

step5:

find expected inflation rate in year 3

=>

3.9% = (3+4% + I3)/3

=>

I3 = 4.7% ......................ans

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