Question

1. Assume that the real risk-free rate is 2.2% and that the maturity risk premium is zero. If a 1-year Treasury bond yield is 6.6% and a 2-year Treasury bond yields 6.8%. Calculate the yield using a geometric average.

a. What is the 1-year interest rate that is expected for Year 2? Do not round intermediate calculations. Round your answer to two decimal places.

b. What inflation rate is expected during Year 2? Do not round intermediate calculations. Round your answer to two decimal places.​

Answer 1

Solution

Geometric yield : Square root (1.066)(1.068) -1

: Square root 1.138488 -1

: 1.06699-1

   : .06699

rounded to .06

a. 1 year interest expected for year 2

(1.066)(1+r2) : (1.068)^2

(1.066)(1+r2) : 1.140624

1+r2 : 1.140624/1.066

   : 1.0700

r2 : 1.0700 - 1

   .07 or 7%

b. inflation rate expected during year 2

Any yield rate above real risk free rate is due to inflation as maturity risk premium is zero

inflation rate is 7- 2.2 : 4.8%