Problem 63 Expected Interest Rate The real riskfree rate is

Problem 6-3 Expected Interest Rate The real risk-free rate is 3%. Inflation is expected to be 2% this year and 4.75% during the next 2 years. Assume that the maturity risk premium is zero a. What is the yield on 2-year Treasury securities? Round your answer to two decimal places b. What is the yield on 3-year Treasury securities? Round your answer to two decimal places.

Solution

For the three-year security, the average expected inflation is (2% + 4.75% + 4.75%)/3 = 3.83 %

the yield on the three-year security is equal to 3% + 3.83% + 3% * 3.83% or 6.95%