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    Suppose the annual yield on a 2-year Treasury bond is 4.5%, while that on a 1-year bond is 3%. k* (=real risk-free rate of interest) is 1 percent, and the maturity risk premium is zero.
    a. Using the expectations theory, forecast the interest rate on a 1-year bond during the second year. (Hint: Under the expectations theory, the yield on a 2-year bond is equal to the average yield on 1-year bonds in years 1 and 2.)

    b. What is the expected inflation rate in Year 1 and Year 2?

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    Solution Preview

    a) forecast the interest rate on a 1-year bond during the second year.

    Interest rate on 1 year Treasury bond= 3.0%
    Interest rate on 2 year Treasury bond= 4.50%

    Let the principal be equal to 1
    Amount after 2 years from 2 year Treasury ...

    Solution Summary

    Forecasts the interest rate in the second year and calculates the expected inflation in years 1 and 2, givn yields on a 1 year and 2 year Treasury bond, the real risk-free rate of interest and the maturity risk premium.