Question

Because of recession, the inflation rate expected for the coming year is only 2%. However, the inflation rate in year 2 and thereafter is expected to be constant at some level above 2%. Assume that the real risk-free rate is r*=3% for all maturities and that there are no maturity premiums. If 3-year Treasury Notes yield 2 percentage points more than 1-year notes, what inflation is expected after year 1?

Answer 1

Risk-Free Rate	=	{(1+Tresury Rate)/(1+Inflation Rate)}-1
For 1-year
i.e. 1.03	=	(1+Treasury Rate)/1.02
i.e. 1.03*1.02	=	1+Treasury Rate
i.e. 1+Treasury Rate	=	1.0506
i.e. Treasury Rate (1-year)	=	0.0506
For 3-year
3-year treasury rate	=	0.0506+0.02
	=	0.07
Risk-Free Rate	=	{(1+Tresury Rate)/(1+Inflation Rate)}-1
i.e. 1.03	=	1+0.0706/1+inflation rate
i.e. 1+inflation rate	=	1.07/1.03
i.e. 1+inflation rate	=	1.04
Thus, inflation	=	1.04-1
	=	0.04

answered by: anonymous