Suppose the inflation rate is expected to be 7.05% next year, 4.6% the following
ID: 2733417 • Letter: S
Question
Suppose the inflation rate is expected to be 7.05% next year, 4.6% the following year, and 3.95% thereafter. Assume that the real risk-free rate, r*, will remain at 2% 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.Calculate the interest rate on 2-year Treasury securities. Round your answer to two decimal places.Calculate the interest rate on 3-year Treasury securities. Round your answer to two decimal places.Calculate the interest rate on 4-year Treasury securities. Round your answer to two decimal places.Calculate the interest rate on 5-year Treasury securities. Round your answer to two decimal places.Calculate the interest rate on 10-year Treasury securities. Round your answer to two decimal places.Calculate the interest rate on 20-year Treasury securities. Round your answer to two decimal places.
Explanation / Answer
Part A
Interest rate = r* + maturity risk premium + average inflation rate
Interest rate one one year = 2% + 0.20% + 7.05%
= 9.25%
Part B
Interest rate = r* + maturity risk premium + average inflation rate
Interest rate one two years = 2% + (0.20% +0.20%) + (7.05% +4.60%)/2
= 2%+ 0.40% + 5.825%
= 8.225%
Part C
Interest rate = r* + maturity risk premium + average inflation rate
Interest rate one three years = 2% + (0.20% +0.20%+.20%) + (7.05% +4.60%+3.95%)/3
= 2%+ 0.60% + 5.20%
= 7.8%
Part D
Interest rate = r* + maturity risk premium + average inflation rate
Interest rate one four years = 2% + (0.20% +0.20%+.20%+0.20%) + (7.05% +4.60%+3.95%+3.95%)/4
= 2%+ 0.80% + 4.8875%
= 7.6875%
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