The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 3-year Treasury securities?

a. 5.2%

b. 6.2%

c. 5.7%

c. 5.7%

Explanation:

The computation of the yield on 3-year Treasury securities is shown below:

= Real Risk - free rate of return + Inflation premium + maturity risk premium

where,

Real Risk - free rate of return = 2%

Inflation premium = (3% + 3% + 5%) : 3 = 3.67%

And, the maturity risk premium = 0%

So, the yield on 3-year Treasury securities is

= 2% + 3.67% + 0%

= 5.67%