Chapter 6, Problem 14P

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

# EXPECTATIONS THEORY AND INFLATION Suppose 2-year Treasury bonds yield 4.1%, while 1-year bonds yield 3.2%. r″ is 1%, and the maturity risk premium is zero. a. Using the expectations theory, what is the yield on a 1-year bond 1 year from now? Calculate the yield using a geometric average. b. What is the expected inflation rate in Year 1? Year 2?

a.

Summary Introduction

To identify: The expected yield.

Expectation Theory:

Expectation theory estimates the future interest without considering the maturity risk. According to the expectation theory, the yield curve of the investment totally depends upon the future expectation of the investors.

Yield:

Yield is the percentage of securities at which the return is provided by the company to its investors. Yield can be there in the form of dividend and interest.

Explanation

Given,

The Treasury bond yield for 1-year is 3.2% or 0.32.

The Treasury bond yield for 2-years is 4.1% or 0.041.

Formula to calculate the expected interest rate derives from the formula of interest rate for the next year,

(1+TreasuryāBondāYieldāforā2-Year)2=((1+TreasuryāBondāYieldāforā1-Year)1(1+ExpectedāInterestāRate)1)(1+ExpectedāInterestāRate)1=((1+TreasuryāBondāYieldāfor

b.

Summary Introduction

To identify: The expected inflation rate in year 1 and year 2.

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