1. The real risk-free rate of interest is 3 percent. Inflation is expected to be 4 percent this coming year, jump to 5 percent next year, and increase to 6 percent the year after (Year 3). According to the expectations theory, what should be the interest rate on 3-year, risk-free securities today?
Year 1 interest rate = (1+Real rate)*(1+Inflation in Year 1) -1 = (1+.03)*(1+.04)-1
Year 2 ...
The solutions presents all the calculations to show how to arrive at the correct answer.