Keena is saving money so she can start a two-year graduate school program two ye

Question

Keena is saving money so she can start a two-year graduate school program two years from now. She doesn't want to take any chances on going to grad school, so she's planning to invest her savings in the lowest risk securities available, Treasury notes (short-term bonds). She will need the first year's tuition in two years and the second year's in three. Use the interest rate model to estimate the returns she can expect on two- and three-year notes. The inflation rate is expected to be 4% next year, 5% in the following year, and 6% in the year after that. Maturity risk generally adds.1% to yields on shorter term notes like these for each year of term. Assume the pure rate is 1.5%.

Explanation / Answer

Interest rate on two year notes:

Inflation in year 1 = 4%

Inflation in year 2 = 5%

So the arthematic average inlfation = (4+5 )/2 = 4.5%

So interest rate on the 2 year note =Real rate + inflation premium + marturity risk premium

Interest rate on the 2 year note = 1.5 + 4.5 + 0.1 = 6.1%

Interest rate on three year notes:

Inflation in year 1 = 4%

Inflation in year 2 = 5%

Inlfation in year 3 = 6%

So arthematic average of inflation premium = (4+5+6)/3 = 5%

So interest rate on the 3 year note =Real rate + inflation premium + marturity risk premium

Interest rate on the 2 year note = 1.5 + 5+ 0.1 = 6.6%

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