Suppose the inflation rate is expected to be 6.15% next year, 4.75% the followin

Question

Suppose the inflation rate is expected to be 6.15% next year, 4.75% the following year, and 2.75% thereafter. Assume that the real risk-free rate, r*, will remain at 1.55% 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. % h. Plot a yield curve based on these data.

Explanation / Answer

Year Real risk free IP** MRP interest rate(Rf+ip+MRP) 1 1.55% 6.15% 0.20% 7.90% 2 1.55% 5.45% 0.40% 7.40% 3 1.55% 4.55% 0.60% 6.70% 4 1.55% 4.10% 0.80% 6.45% 5 1.55% 3.83% 1.00% 6.38% 10 1.55% 3.29% 1.00% 5.84% 20 1.55% 3.02% 1.00% 5.57% interest rate(Rf+ip+MRP) 1-year Treasury securities 7.90% 2-year Treasury securities 7.40% 3-year Treasury securities 6.70% 4-year Treasury securities 6.45% 5-year Treasury securities 6.38% 10-year Treasury securities 5.84% 20-year Treasury securities 5.57% Year inflation rate Average Expected Inflation Rate Average Expected Inflation Rate 1 6.15% 6.15% 6.15% 2 4.75% =+(6.15%+4.75%)/2 5.45% 3 2.75% =+(6.15%+4.75%+2.75%)/3 4.55% 4 2.75% =+(6.15%+4.75%+2.75%+2.75%)/4 4.10% 5 2.75% =+(6.15%+4.75%+2.75%+2.75%+2.75%)/5 3.83% 10 2.75% =+((2.75%*8)+(4.75%+6.15%))/10 3.29% 20 2.75% =+((6.15%+4.75%)+(2.75%*18))/20 3.02%

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