Question

The real risk-free rate is 3.5%. Inflation is expected to be 1.75% this year and 5% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? Do not round intermediate calculations. Round your answer to two decimal places. % What is the yield on 3-year Treasury securities? Do not round intermediate calculations. Round your answer to two decimal places. %

Answer 1

Nominal Yield on a Treasury security = Real risk free rate + Inflation premium + Maturity risk premium

Now, maturity risk premium = 0

Inflation premium is average of inflation over life of bond.

For a 2-Year Treasury security

Inflation premium = (1.75% + 5%)/2 = 3.375%

Nominal Yield on Treasury Security = 3.5% + 3.375% = 6.88%

For a 3-Year Treasury security

Inflation premium = (1.75% + 5% + 5%)/3 = 3.917%

Nominal Yield on Treasury Security = 3.5% + 3.917% = 7.42%