A thirty-year U.S. Treasury bond has a 4.0 percent interest rate. In contrast, a

Question

A thirty-year U.S. Treasury bond has a 4.0 percent interest rate. In contrast, a ten-year Treasury bond has an interest rate of 2.5 percent. A maturity risk premium is estimated to be 0.2 percentage points for the longer maturity bond. Investors expect inflation to average 1.5 percentage points over the next ten years.

a. Estimate the expected real rate of return on the ten-year U.S. Treasury bond.

b. If the real rate of return is expected to be the same for the thirty-year bond as for the ten-year bond, estimate the average annual inflation rate expected by investors over the life of the thirty-year bond.

Explanation / Answer

a) expected real return is approximately 2.5 - 1.5 = 1%

b) inflation is 4 - real rate - maturity risk = 4 - 1 - 0.2 = 2.8%

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