6 3. (Example 5-3)Jane is saving money so she can start a two year graduate scho

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6

3. (Example 5-3)Jane is saving money so she can start a two year graduate school program two years from now. She doesn?t want to take any chances going to graduate school, so she?s planning to invest her savings in the lowest risk securities available, Treasury notes (short-term bonds). She will need the first year?s tuition in two years and the second year?s in three. Use the interest rate model to estimate the returns she can expect on two and three year notes. The inflation rate is expected to be 3% next year, 4% in the following year, and 5% in the year after that. Maturity risk generally adds .2% to yields on shorter term notes like these for each year of term. Assume the pure rate is 1.0%. Treasury securities have no liquidity or default risks, so the interest rate model becomes t k=k*INFL+MR

Explanation / Answer

Pure rate = 1% Inflation rate Year 1= 3% Year 2= 4% Year 3= 5% Since, Jane is investing in Treasury securities, the expected return shall be combination of Pure rate and Inflation rate, and also maturity risk Return in Year 1 {[(1.01*1.03)-1]*100}+0.2= 4.05% Return in Year 2 {[(1.01*1.04)-1]*100}+0.2= 5.06% Return in Year 3 {[(1.01*1.05)-1]*100}+0.2= 6.07%

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