Suppose the inflation rate is expected to be 6.9% next year, 4.45% the following

Question

Suppose the inflation rate is expected to be 6.9% next year, 4.45% the following year, and 2.15% thereafter. Assume that the real risk-free rate, r*, will remain at 2.15% 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% Comment if any questions.

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