Assume investors demand a real rate of return equal to 3 percent and that there is no maturity risk premium associated with Treasury securities.According to the Wall Street Journal, the average nominal yields on risk-free Treasury securities with different maturities are: What is the one-year nominal interest rate and the inflation premium that is expected in Year 4?

Question

Assume investors demand a real rate of return equal to 3 percent and that there is no maturity risk premium associated with Treasury securities.According to the Wall Street Journal, the average nominal yields on risk-free Treasury securities with different maturities are:  What is the one-year nominal interest rate and the inflation premium that is expected in Year 4?

Quizplus · Accepted Answer

The one-year nominal interest rate is given as 2.26%. To calculate the inflation premium that is expected in Year 4, we need to use the information provided in the table. The difference between the yield on a Treasury Inflation-Protected Security (TIPS) and the yield on a nominal Treasury security of the same maturity gives us the expected inflation rate. According to the table, the yield on a 4-year TIPS is 2.82% and the yield on a 4-year Treasury security is 6.42%. Therefore, the inflation premium is 6.42% - 2.82% = 3.6%. Since we know that investors demand a real rate of return of 3%, the expected nominal interest rate in Year 4 is 3% + 3.6% = 6.6%. Therefore, the answer is D, 5.6% and 2.6%.

Assume Investors Demand a Real Rate of Return Equal to 3