Homework Answers
23. a)
A Treasury Bill is a short term liquid debt instrument issued by/on behalf of a government , So it carries no default risk, maturity risk or liquidity risk
Hence Rate for treasury bill = real risk free rate + Inflation premium = 4% +7% = 11%
As liquid market dont exist for long term T-bonds,
Rate for Long term T-bonds = real risk free rate + Inflation premium + maturity premium + liquidity premium
=4%+7%+1%+2% =14%
b)
Rate of 3 year T-note = real risk free rate + Inflation premium
=> 13% = 3% + Inflation premium
=> Inflation premium = 10%
As the average inflation rate over next 2 years = 11%
Inflation premium = 10% = Average inflation for 3 years
=> (11%+11%+ inflation during year 3) / 3 = 10%
=> inflation during year 3 = 8%
So, implied expected inflation rate during year 3 is 8%
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