Question

Assume that the real, risk-free rate of interest is expected to be constant over time at 3.0 percent, and that the annual yield on 4-year Treasury securities is 7.15 percent, while the annual yield on 6 year Treasury securities is 7.75 percent: you may assume that the default risk and liquidity premium on Treasury securities is zero. Also assume that the maturity risk premium for all securities can be estimated as MRP i

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=(0.15%) ∗
(t−1), where t is the number of periods until maturity. Given this information, and assuming that the expected rate of inflation for Year 1 is 3.0 percent, for Year 2 is 3.5%, for Year 3 is 4.0 percent (you should now be able to determine what the expected rate is for Year 4), and that the expected rate of inflation for Year 6 is 4.50 percent, determine what the market must anticipate the rate of inflation will be in Year 5. 4.70% 4.30% 4.50% 4.10% 3.90%

Answer 1

The market must anticipate the rate of inflation will be 4.50% in Year 5.

Step-by-step explanation:

To determine what the market must anticipate the rate of inflation will be in Year 5, we can use the maturity risk premium formula.

The maturity risk premium is given by MRPi = (0.15%)*(t-1), where t is the number of periods until maturity.

In this case, we have a 6-year Treasury security, so t = 6.

Plugging in the values, we get MRP6 = (0.15%)*(6-1) = 0.75%.

Now, we need to find the expected rate of inflation for Year 5.

Given that the expected rate of inflation for Year 6 is 4.50 percent, we can assume that the expected rate of inflation for Year 5 will be the same, i.e., 4.50 percent.