The market expects inflation to do the following: remain at 1% for the next year and...

The market expects inflation to do the following: remain at 1% for the next year and then increase to 2% for the next two years.
1. What is the inflation premium for a 1-year security?
2. For a 3-year security?
3. If the real risk-free rate is 4% and the maturity risk premium is 0, what is the yield on a 1-year Treasury bond?
4. A 3-year Treasury bond?

Expert Solution

Year	Inflation %	inflation premium for a 1-year security?	inflation premium for a 3-year security?		Working
Y1	1%	1%	1.00%	a
Y2	2%		1.02%	b	Y1+2%of Y1
Y3	2%		1.04%	c	Y2+2%of Y2
	Total	1.00%	3.06%	A

Yield on		1-year Treasury bond	3-year Treasury bond
Year	real risk-free rate is	4%	4%		inflation premium	Working
Y1		4%	4%	d	0.0400%	d*a
Y2		0	4.16%	e	0.0424%	e*b
Y3		0	4.33%	f	0.0451%	f*c
	real risk-free yield	4.00%	12.49%	g	0.1275%
Add: maturity risk premium		0	0
Total Inflation Premium		0.04%	0.13%			d*a
Total Yield		4.04%	12.62%	B		g

Result						Working
Inflation premium for a 1-year security?			1.00%			A
Inflation premium for a 3-year security?			3.06%			A
yield on a 1-year Treasury bond			4.04%			B
yield on a 3-year Treasury bond			12.62%			B

jeff jeffy answered 8 months ago

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