Assume that the real risk-free rate is 2% and that the maturity risk premium is zero. If a 1-year Treasury bond yield is 5% and a 2-year Treasury bond yields 7%, what is the 1-year interest rate that is expected for Year 2? Calculate this yield using a geometric average. What inflation rate is expected during Year 2? Comment on why the average interest rate during the 2-year period differs from the 1-year interest rate expected for Year 2.

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Rolex

13 October, 14:09

Assume that the real risk-free rate is 2% and that the maturity risk premium is zero. If a 1-year Treasury bond yield is 5% and a 2-year Treasury bond yields 7%, what is the 1-year interest rate that is expected for Year 2? Calculate this yield using a geometric average. What inflation rate is expected during Year 2? Comment on why the average interest rate during the 2-year period differs from the 1-year interest rate expected for Year 2.

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Laura Cummings · Answer 1

1-year Treasury bond yield is 5% and a 2-year Treasury bond yields 7%

One year interest rate expected for year 2 = [ (1+r2) ^2 / (1+r1) ]-1 = [ (1+0.07) ^2 / (1+0.05) ]-1 = 1.0904 - 1 = 9.04%

Inflation rate during year 2 = One year interest rate expected for year 2 - inflation rate = 9.04%-2% = 7.04%