Question

16.  Problem 6.15

EXPECTATIONS THEORY

Assume that the real risk-free rate is 2% and that the maturity risk premium is zero. If a 1-year Treasury bond yield is 6.4% and a 2-year Treasury bond yields 6.7%. Calculate the yield using a geometric average.

1. What is the 1-year interest rate that is expected for Year 2? Do not round intermediate calculations. Round your answer to two decimal places.
   
   %
   
2. What inflation rate is expected during Year 2? Do not round intermediate calculations. Round your answer to two decimal places.
   
   %
   
3. Comment on why the average interest rate during the 2-year period differs from the 1-year interest rate expected for Year 2.
   
   1. The difference is due to the real risk-free rate reflected in the two interest rates. The real risk-free rate reflected in the interest rate on any security is the average real risk-free rate expected over the security's life.
   2. The difference is due to the fact that the maturity risk premium is zero.
   3. The difference is due to the fact that we are dealing with very short-term bonds. For longer term bonds, you would not expect an interest rate differential.
   4. The difference is due to the fact that there is no liquidity risk premium.
   5. The difference is due to the inflation rate reflected in the two interest rates. The inflation rate reflected in the interest rate on any security is the average rate of inflation expected over the security's life.

Answer 1

SEE THE IMAGE. ANY DOUBTS, FEEL FREE TO ASK. THUMBS UP PLEASE

? v . 1 05:58 ENG 17-02-2020 25 X U435 O P Q R S T U V W 416 417 418 419 420 421 YIELD ON 2 YEAR TREASURY BOND YIELD ON 1 YEAR TREASURY BOND 6.70% 1R2 6.40% 1R1 422 1 YEAR RATES 1 YEAR FROM NOW = 2f1 2f1 = (1+1R2)^2/(1+1R1)^1-1 = ((1+0.067)^2/(1+0.064)^1) -1 = 7.00% 425 426 427 b 428 EXPECTED INFLATION RATE IN YEAR 2 RATE OF INTEREST IN YEAR 2 = 7.00% = IP = 429 r* + IP 2.00% + IP 5.00% 430 V THE DIFFERENCE IS DUE TO INFLATION RATE REFLECTED IN TWO INTEREST RATES 431 432 433 434 435 436 437 438 439 ... AFN BANKING NOTE Sheet2 51 53 CLEAN PRICE $10 BIDDING, UNDERWRITING EUAC AW LIFE LP, IP, MRP, INFLATION WARRANT refund ... : )