Suppose you and most other investors expect the inflation rate to be 8% next year, to fall to 5% during the following year, and then to remain at a rate of 3% thereafter.

Problem 4-23
Determinants of Interest Rates

Suppose you and most other investors expect the inflation rate to be 8% next year, to fall to 5% during the following year, and then to remain at a rate of 3% thereafter. Assume that the real risk-free rate, r*, will remain at 2% and that maturity risk premiums on Treasury securities rise from zero on very short-term securities (those that mature in a few days) to a level of 0.2 percentage points for 1-year securities. Furthermore, maturity risk premiums increase 0.2 percentage points for each year to maturity, up to a limit of 1.0 percentage point on 5-year or longer-term T-notes and T-bonds.

Calculate the interest rate on 1-year Treasury securities. Round your answer to two decimal places.
  %
Calculate the interest rate on 2-year Treasury securities. Round your answer to two decimal places.
  %
Calculate the interest rate on 3-year Treasury securities. Round your answer to two decimal places.
  %
Calculate the interest rate on 4-year Treasury securities. Round your answer to two decimal places.
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Calculate the interest rate on 5-year Treasury securities. Round your answer to two decimal places.
  %
Calculate the interest rate on 10-year Treasury securities. Round your answer to two decimal places.
  %
Calculate the interest rate on 20-year Treasury securities. Round your answer to two decimal places.
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Solutions

Expert Solution

GIVEN:

Risk free rate r*= 2%

Inflation rate for yr 1 = 8%

Inflation rate for yr 2= 5%

Inflation rate for yr 3 and there after = 3%

Maturity risk premium for yr 1 = 0.2%

Maturity risk premium increases every yr by 0.2% up to 1%

Interest rate r = r* + Inflation Premium + Maturity Premium

MATURITY	RISK FREE INTEREST %	INFLATION RATE %	MATURITY RISK PREMIUM %	INTEREST RATE OF BOND % (answer)
1	2	8	0.2	10.2
2	2	5	0.4	7.4
3	2	3	0.6	5.6
4	2	3	0.8	5.8
5	2	3	1	6
10	2	3	1	6
20	2	3	1	6

jeff jeffy answered 2 years ago

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