Question

Assume that a three-year Treasury note (T-note) has no maturity premium, and that the real risk-free rate of interest is 3 percent. If the T-note carries a nominal risk-free rate of return of 13 percent and if the expected average inflation rate over the next two years is 9 percent, what is the implied expected inflation rate during Year 3

Answer 1

Answer: 12%

Step-by-step explanation:

First find the Inflation premium:

= Nominal risk free rate - Real risk free rate

= 13% - 3%

= 10%

Plug it into the following equation:

Inflation premium = { (2 * expected average inflation rate over the next two years) + Inflation rate for third year) } / 3

10% = { (2 * 9%) + 1₃} / 3

3 * 10% = { (2 * 9%) + 1₃}

30% = 18% + I₃

I₃ = 30% - 18%

I₃ = 12%