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?
A)7%
B)12%
C)9%
D)11%
E)18%

Question

Quizplus · Accepted Answer

To find the implied expected inflation rate during Year 3, we must first calculate the nominal risk-free rate of return for Year 3. We can use the formula: 
Nominal risk-free rate = Real risk-free rate + Expected inflation rate 
Given that the nominal risk-free rate for the T-note is 13% and the real risk-free rate is 3%, we can solve for the expected inflation rate: 
13% = 3% + Expected inflation rate 
Expected inflation rate for Year 3 = 10%
Therefore, the answer is B) 12%, since the expected average inflation rate over the next two years is 9% and the implied expected inflation rate during Year 3 is 10% (which is closer to 9% than 18%).

Assume That a Three-Year Treasury Note (T-Note) Has No Maturity