Question

The real risk-free rate of interest is 4%. Inflation is expected to be 2% this year and 4% during each of the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities?

Answer 1

Answer:

For the 2 year treasury securities it was 7%, and for a 3 year treasury securities it was 7.33%

Explanation:

From the example,

The real risk rate of interest is= 4%

The inflation expectation of this year=2%

Inflation expected  for the next 2 years=4%

Maximum risk premium=0

Therefore

Rt= r* + (Inflation/ year)

Rt2= 4 + (2 + 4 / 2) = 7%

Rt3= 4 + (2 + 4 / 3) = 7.33%