Assume that the real risk-free rate is 2% and that the maturity risk premium is

Question

Assume that the real risk-free rate is 2% and that the maturity risk premium is zero. Also assume that the 1-year Treasury bond yield is 4.55% and a 2-year bond (of similar risk) yields 6.8%.

a. What is the 1-year interest rate that is expected for Year 2? Round your answer to two decimal places.
%

b. What inflation rate is expected during Year 2? Round your answer to two decimal places.
%

c. Comment on why the average interest rate during the 2-year period differs from the 1-year interest rate expected for Year 2.
-Select-IIIIIIIVV

Explanation / Answer

one-year T-bond yields 4.55% and a two-year T-bond yields 6.8%, then the investors expect to yield ? SO we have (1+6.8%)^2 = (1+4.55%)*(1+X), solve for X(forward rate) = (1+6.8%)^2/(1+4.55%) - 1 = 9.10% .....ans (a) r = r* + IP + DRP + LP + MRP Where r = required interest rate = 9.10% r* = real risk-free rate of interest =2% IP = inflation premium = ?? DRP = default risk premium = 0 LP = liquidity premium = 0 MRP = maturity risk premium =0 So we have IP = r-r*-MRP = 9.10% - 2% - 0 = 7.10% ...........Ans (b) c. Average interest rate during the 2-year period differs from the 1-year interest rate expected for Year 2 because of Expectation theory which states that the shape of the yield curve depends on investor’s expectations about future interest rates (inflation rates)

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