Question

Consider the following spot interest rates for maturities of one, two, three, and four years. r1=3.57% r2=3.79% r3=3.1% r4=4.26% If inflation in year 3 (that is, between the end of year 2 and end of year 3) is expected to be 2.02 percent, what real rate (in percent) does this imply for year 3?

Answer 1

Nominal rate in year 3 (that is, between the end of year 2 and end of year 3) = (1+r₃)³ / (1+r₂)² - 1

Nominal rate in year 3 = (1+3.1%)³ / (1+3.79%)² - 1

Nominal rate in year 3 = 1.7337%

Expected inflation in year 3 = 2.02%

Therefore Real Rate = (1+Nominal rate) / (1+inflation) - 1 = 1.017337 / 1.0202 - 1 = (-0.281%)

Therefore inflation of 2.02% in year 3 implies that year 3 real rate will be negative, that is (-0.281%)

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