Problem 63 Expected Interest Rate The real riskfree rate is

Problem 6-3 Expected Interest Rate The real risk-free rate is 2.75%. Inflation is expected to be 1.75% this year and 4.5% 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 (1.75% + 4.5% + 4.5%)/3 = 3.583 %

the yield on the three-year security is equal to 2.75% + 3.583% + 2.75% * 3.583% or 6.43%