Question

In: Finance

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

  1. 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?

Solutions

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


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