Question

The real risk-free rate is 2.25%. Inflation is expected to be 1.5% this year and 3.5% during the next 2 years. Assume that the maturity risk premium is zero.

What is the yield on 2-year Treasury securities? Do not round intermediate calculations. Round your answer to two decimal places. %

What is the yield on 3-year Treasury securities? Do not round intermediate calculations. Round your answer to two decimal places. %

Answer 1

Answer:

Yield on Treasury security = Risk free rate + Average inflation + Risk premium

Average inflation = (Inflation of year 1 + Inflation of year 2 + .....) / Number of years

Given: Risk free rate = 2.25%, Inflation at year 1 = 1.5%, inflation for 2 years = 3.5%, Risk premium = 0

Average two years inflation: (1.5%+3.5%) / 2 = 2.5%

Average three years inflation: (1.5%+3.5%+3.5%) / 3 = 2.83%

Putting the given values in the formula, we get:

Yield on 2 year Treasury security: 2.25% + 2.5% = 4.75%

Yield on 3 year Treasury security: 2.25% + 2.83% = 5.08%