Q.04 (a)Assume that the real risk-free rate, r*, is 2.7% and that inflation is expected to be 7.5%

in Year 1, 5% in Year 2, and 4% thereafter. Assume also that all Treasury securities are highly

liquid and free of default risk. If 2-year and 5-year Treasury notes both yield 10%, what is the

difference in the maturity risk premiums (MRPs) on the two notes; that is, what is MRP5 minus

MRP2?

(b) Because of a recession, the inflation rate expected for the coming year is only 3%. However,

the inflation rate in Year 2 and thereafter is expected to be constant at some level above .1%.

Assume that the real risk-free rate is r* = 2% for all maturities and that there are no maturity

premiums. If 3-year Treasury notes yield 2 percentage points more than 1-year notes, what

inflation rate is expected after Year 1?