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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 5% and a 2-year Treasury bond yields 7%, what is the 1-year interest rate that is expected for Year 2? Calculate this yield using a geometric average. What inflation rate is expected during Year 2? Comment on why the average interest rate during the 2-year period differs from the 1-year interest rate expected for Year 2.

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Answer:

Explanation:

1-year Treasury bond yield is 5% and a 2-year Treasury bond yields 7%

One year interest rate expected for year 2 = [(1+r2)^2 / (1+r1) ]-1 =[ (1+0.07)^2 / (1+0.05) ]-1   = 1.0904 -1  = 9.04%

Inflation rate during year 2 = One year interest rate expected for year 2 – inflation rate  = 9.04%-2%  =7.04%

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