Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 4.20%.What rate of return would you expect on a 1-year Treasury security,assuming the pure expectations theory is valid? Include cross-product terms,i.e. ,if averaging is required,use the geometric average.(Round your final answer to 2 decimal places. )
A) 7.30%
B) 7.85%
C) 7.69%
D) 6.91%
E) 5.96%

Question

Quizplus · Accepted Answer

According to the pure expectations theory, the expected rate of return on a 1-year Treasury security can be calculated as follows:

1 + R = (1 + r*) x (1 + i)

where:
R = expected rate of return on a 1-year Treasury security
r* = real risk-free rate = 3.50%
i = expected rate of inflation = 4.20%

Substituting the values into the equation, we get:

1 + R = (1 + 0.035) x (1 + 0.042)
1 + R = 1.0785
R = 0.0785 or 7.85% (rounded to two decimal places)

Therefore, the best choice is B.

Suppose the Real Risk-Free Rate Is 3