Question

Projections for inflation for the next few years are as follows: year 1       2% year 2      ...

Projections for inflation for the next few years are as follows:

year 1       2%

year 2       3%

year 3       5%

a) Calculate (and show your work) the inflation premium for a 2-year bond -- in other words, what is the average annual inflation over this bond's life?

b) Calculate (and show your work) the inflation premium for a bond maturing in 3 years -- in other words, what is the average annual inflation over the life of this bond?

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Homework Answers

Answer #1

a. Inflation for the bond = 1.02 * 1.03 =1.0506
     Annualized premium = √1.0506= 0.0249 or 2.4988%

b. Total inflation for a 3 year bond = 1.02 *1.03 * 1.05 = 1.1031
      Annualized premium = (1.1031) ^1/3 = 3.3258%

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Hope this answer your query.

Feel free to comment if you need further assistance. J

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