Suppose you and other investors expect that inflation will be 3% next year, to rise to 5% during the following year and then to remain at 7.4% thereafter. Further you expect that the real risk free rate of interest will remain at 2% and the maturity risk premium on treasury securities will rise from .2% for one year bonds. Maturity risk premiums are expected to increase 0.2% for each year to maturity up to a limit of 1.0 percentage point on 5-year or longer term T-bonds.

What is the return on a 4-year bond? Write your answer as a percentage i.e. 8% is 8.

Question 2

One-year Treasury securities yield 6%. The market anticipates that 1-year from now 1-year Treasury securities will yield 4%. If the pure expectations theory is correct, what should be the yield today for 2-year Treasury securities? Write your answer as a percentage, i.e. for example write 8% as 8.