Question

The real risk-free rate is 2.5%. Inflation is expected to be 2.5% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero.

1. What is the yield on 2-year Treasury securities? Do not round intermediate calculations. Round your answer to two decimal places.
   
   %
   
2. What is the yield on 3-year Treasury securities? Do not round intermediate calculations. Round your answer to two decimal places.
   
   %

Answer 1

Yield on a treasury is calculated as follows:
r = rf + IP + MRP ….. equation 1
where,

r = yield on treasury securities

rf = real risk free rate

IP = inflation premium
MRP = maturity risk premium

a) Inflation premium for a 2 - year securities = (2.5% + 4%) / 2
= 3.25%

putting in equation 1
Yield for a 2- year Treasury securities = 2.5% + 3.25% + 0%
= 5.75%
Yield on 2-year treasury securities is 5.75%

b) Inflation premium for a 3-year treasury securities = (2.5% + 4% + 4% ) / 3
   = 3.50%

putting in equation 1
Yield for a 3- year Treasury securities = 2.5% + 3.50% + 0%
= 6.00%

Yield on 3-year treasury securities is 6.00%