Suppose you and most other investors expect the inflation rate to be 3.00% next

Question

Suppose you and most other investors expect the inflation rate to be 3.00% next year, 4.00% during the following year, and then to remain at a rate of 5.00% thereafter. Assume that the real risk-free rate will remain at 1.00% and that maturity risk premiums on Treasury securities rise from zero on very short- term securities to a level of 0.10% percentage points for 1-year securities. Furthermore, maturity risk premiums increase 0.10 percentage points for each year to maturity, up to a limit of 1.00 percentage point on 10-year or longer-term T-notes and T-bonds.
Calculate the interest rate on a 5-year Treasury securities.

Question 89 options:

5.70%

6.30%

5.90%

6.10%

5.70%

6.30%

5.90%

6.10%

Explanation / Answer

interest rate on treasury security= real rate + maturity premium + average inflation during the period

Real rate required= 1%

maturity premium = 0.1% per year * 5 years= 0.5%

average inflation= (3%+4%+5%+5%+5%)/= 4.4%

Interest rate= 1% + 0.5% + 4.4%= 5.9%

third option is correct

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