Question

Determinant of Interest Rates

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

What is the yield on 2-year Treasury securities? Round your answer to two decimal places.
%

What is the yield on 3-year Treasury securities? Round your answer to two decimal places.
%

Answer 1

yield on 2yr bond

r = real risk free rate + Inflation Premium + Market risk premium

            r = 2 + ((2+4)/2) + 0

            r = 5%

yield on 3yr bond

r = real risk free rate + Inflation Premium + Market risk premium

            r = 2 + ((2+4 + 4)/3) + 0

            r = 5.33%